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by  BlueBay Fixed Income teamM.Dowding Feb 23, 2024

Passionate, insightful, contrarian at times and always a true thought-leader in his field, Mark Dowding shares fresh fixed income insights every Friday. His musings on the week cover macro developments, bond market trends and his latest positioning thoughts, with the odd joke thrown in for good measure.

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Key points

  • Fixed income markets have been quiet, while corporate earnings have continued to impress, and this has helped the resilient equity market.

  • Meetings with policymakers suggest that central bankers are generally content with market pricing, which is a marked change from the beginning of the year.

  • In the UK, fiscal easing will be a theme next month, while there has been more fiscal prudence in the Eurozone.

  • Looking ahead, our main focus will be US PCE Core data. An upside surprise could see yields push higher, if falling inflation is questioned.

Financial markets were particularly quiet at the start of the past week, with government bonds trading in an unusually narrow range. With few data releases to focus on, it was telling to observe just how many fixed income commentators seemed tempted to turn into armchair analysts on the Nvidia stock price, in the run-up to the company’s latest quarterly earnings release on Wednesday.

AI is a prevalent theme and a technology which holds the potential to materially reshape the world we know, in the coming generation and beyond. Ultimately, the deployment of AI may make certain jobs redundant. Yet, as we have seen many times in the past, society has an ability to utilise workers in new roles and jobs, many of which may not yet even exist.

That said, focussing on the shorter-term implications, there is a bit of a sense that the frenzy around AI and needing to develop an AI strategy is fuelling something of an investment boom in the US. At a time when many have been looking for economic activity to slow, this is another factor that could argue that the current economic expansion still has room to run.

Certainly, CEOs don’t want to get left behind the crowd and the AI narrative is helping fuel booming demand for companies such as Nvidia and its kin. Nevertheless, the hype around AI risks creating a bubble in the price of such stocks, as we have seen many times in the past when disruptive technologies emerge, as they did with the dot com boom of the late nineties, or even the growth of railways in the 1900s.

At some point, it is inevitable that a company like Nvidia won’t be able to keep beating inflated estimates and a moment of disappointment will arrive. From this point of view, you could say that company management may find themselves stuck in an invidious position and one might be tempted to feel sorry for them, were they not likely to be ‘laughing all the way to the bank’ (as we Brits might say).

That said, earnings this week continued to impress, and this has helped to continue to underpin a resilient equity market. Stocks have managed to dismiss recession risk and valuations have managed to hold up, notwithstanding a rise in the path of interest rates, compared to what was previously discounted. Risk assets continue to be helped by a general belief that the latest poor inflation prints were something of a one-off and the disinflationary trend should resume next month.

That said, we are inclined to look for upside risks to next week’s PCE Core data, following a sharper-than-expected rise in US producer prices. We also see tightness in the labour market posing a risk to wages and from this point of view, there is a risk that the declining inflation orthodoxy could be challenged over the next couple of weeks.

This aside, market expectations for the Federal Reserve (Fed) are now not too far from what it has been projecting. Meetings with policymakers over the past week suggest that central bankers are generally content with market pricing, having been concerned at the much more aggressive timeline for rate cuts, which was implied in futures markets when we started 2024.

From this point of view, we continue to express no active position in US rates, though we continue to run shorts in in JGBs and gilts elsewhere. Consequently, we remain exposed to a general short duration beta at an overall level, and we see this as consistent with a broad-based view that remains quite constructive on the US economy. We also see signs of stronger growth in Europe in Q1, even if the trend across the continent is much depressed relative to US levels.

In the UK, fiscal easing will be a theme next month and would project that Sunak will be tempted to use most all of the £20bn of fiscal headroom, which the OBR is likely to sign off on. Loose fiscal policy has also been a theme we have discussed in the US, and we think that creeping concerns with respect to debt sustainability could bleed into markets, with investors demanding an increase in the term premium required to hold long-dated assets.

In this context, there has been more fiscal prudence, relatively speaking, in the Eurozone. However, a call for EUR100 billion for defence spending by Estonia this week highlights that there are significant challenges, which leaders across the continent will need to stand up to, with Russia now pushing towards the ascendancy in Ukraine. There is a sense from many policymakers that Putin cannot be permitted to prevail. Yet, in this context, it strikes us that there is currently too much talk and too little action, when it comes to anyone taking leadership, for ensuring this; especially when accounting for the risk that the US will start to draw back its support, should Trump win the presidency.

A Trump victory would also likely push back on immigration and also look to raise tariffs. These are both policy directives, which may raise medium-term inflation concerns. This direction of travel may also warrant a steeper yield curve, though in the recent sell off in US rates, we have witnessed something of a flattening trend as investors exit consensual positions. From this point of view, we see steepening trades becoming more attractive to enter, but see a lower risk way of positioning for this in the 10/30 curve shape, rather than focussing on 2/10 maturities.

Meanwhile, the latest Fed minutes confirmed no rush on the part of the FOMC to start cutting rates, with several participants highlighting the risk of easing policy too early. Certainly, a topic that has come up in conversation with policymakers is that current economic releases do not suggest that current US interest rates are particularly restrictive, and this is leading to some greater questioning around the appropriate level for R* and a sense for where neutral interest rates may now be. From this point of view, as we head towards next month’s FOMC, we think there is scope for an upward revision to the ‘long term dot’, which currently sits at 2.5% – a level now widely regarded as too low.

European PMI data pointed to an uptick in activity in Q1, relative to the end of last year. Although this might imply an exit to recession, the reality is that growth continues to hover around zero. Stagnation is probably a more accurate prognosis than recession at this point, noting that there has been no evidence of a material weakening in the labour market.

Meanwhile, within the data we continue to see Southern Europe outperforming the north, with the German manufacturing sector continuing to lag as ‘ze sickmanner of Europe’. In that respect, one might wonder whether an increase in German military production could offer an answer to that, but it remains challenging to think that Scholz and his colleagues will ever be so decisive.

Elsewhere, UK data were also slightly better. Bank of England (BoE) comments suggest to us that they are largely content with market pricing of future interest rates. Statistically speaking, headline UK CPI will fall in Q2 before heading higher again.

Yet with wage settlements still above 5%, and above-inflation increases in prices ranging from broadband to insurance and council taxes, we see core service inflation remaining problematic. Even chocolate prices are now set to jump; bad news for those of us with something of a sweet tooth.

With an upcoming fiscal giveaway also in prospect, we continue to hold a view that UK inflation will surprise to the upside of consensus estimates and therefore it will be difficult for the BoE to cut rates this year as many are hoping.

In Japan, Ueda has been making comments highlighting that the BoJ is becoming more confident in the inflation trajectory. It was also noteworthy to see Toyota announce a pay deal >6% this year, reinforcing our expectation that the Shunto round will see an outcome around 5%, which would be 1% higher than last year, and the highest wage growth for over 30 years.

Japanese equities have reached new record highs, buoyed by strong Japanese corporate earnings. In part, these have been boosted by a weak yen and also building pricing power. From this point of view, it is now encouraging to see these gains being passed on to workers, as policymakers have hoped to see.

Given how tight the Japanese labour market is, one may suggest that this is long overdue. Nevertheless, it seems that confidence is continuing to build, that inflation has moved more sustainably to a level around 2%.

Robust price action in equities has continued to support price action in credit, with index spreads continuing to tighten on strong underlying demand for paper. European spreads remain wide relative to US counterparts and so have been outperforming in the rally.

Similarly, cash bond spreads are benefitting from supportive supply and demand technical, more than is the case for CDS spreads, leading the basis between cash and CDS to continue to tighten. European financials have continued to outperform. On a month-to-date basis, the spreads of subordinated debt in the CoCo index are 25bps tighter in February and now stand 100bps inside levels seen last October. Notwithstanding this, we still see scope for these trends to continue to run further.

In FX, the dollar was weaker over the past several days, which is somewhat surprising given the narrative of US growth exceptionalism. Broadly speaking, volatility across FX as an asset class has been very muted of late, notwithstanding much larger movements in rates and credit asset classes.

Given the global macro divergence we see around us, this feels anomalistic. We continue to see a theme, where certain currencies will be exposed to an unwind of carry as interest rates fall. Here the Hungarian forint and Colombian peso are two favoured shorts. Elsewhere, we think that the dollar is more likely to trend stronger, than weaker, versus the euro and so are looking at a possible entry to add long dollar risk in the Euro cross.

Looking ahead

Our main focus in the coming week will be US PCE Core data. An upside surprise could see yields continue to push higher if falling inflation is questioned. Meanwhile, a more benign print and investors will start to look through CPI as the statistical outlier – particularly noting the impact of imputed rents on these data.

Aside from this, it will also be interesting to see how US stock sentiment continues to push to the upside with 5,000 breached on the S&P and the earnings season moving behind us. We have recently met with European investors who seem to be belatedly jumping onto the US stock rally ‘in the only economy with any growth’ and increasingly bears seem to become scarcer in their number.

In a sense, this seems yet a further rationalisation of the FOMO investment theme. There Is No Alternative (TINA) isn’t much of an investment strategy, but until sentiment shifts, it seems difficult to project a turn for the time being.

At some point, this may have a sticky ending. However for now, even AI investment models seem to want to jump onto the AI band wagon, in a self-reinforcing loop. At this rate, AI would be the only thing we might be talking about, were it not to be for some of the small matters going on in the world around geopolitics.

These points aside, it does seem appropriate to question just how much the Fed will need to lower rates, if we are in the middle (or early stages) of an AI spending boom. Meanwhile it is also reassuring to remember that human talent and human skills are unlikely to be rendered obsolete in the near future….(and I can make a promise that I won’t be outsourcing this commentary to a robot anytime soon!)

Learn more from our experts on their perspectives on the latest developments in global credit and the state of the markets.

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