US yields reached cyclical highs over the past week, with 2-year and 10-year Treasuries breaking previous support levels of 5% and 4.25%, respectively.
After our meetings with US policymakers last week, we have the impression that the Fed remains concerned that the negative outcome, if it does not tighten monetary policy sufficiently, could potentially be more painful than the result of excessive tightening and subsequent the need to change course. .
There are fears that if inflation gets stuck in the 3-4% range, expectations could lose their anchor over time and, furthermore, that the risk of a shock pushing inflation back to 5% could make life very difficult.
So far, however, GDP growth continues to fluctuate around its trend, and we are struck by the fact that consumption is not slowing down. Low prepayments on mortgages mean that only a small fraction of borrowers are affected by the rise in rates at the moment.
Meanwhile, lower real estate market dynamism results in more limited demand for durable goods, but instead a higher demand for services and empirical consumption. You can see this in hotel prices and live music tickets.
In many ways, this has been Taylor Swift’s summer, and it seems like everywhere she’s toured, she’s managed to rock prices and rock the ground!
At the same time, we see signs of inflation slowing elsewhere, and as China slips into recession territory, weakening commodity prices could also drive down costs. Monetary policy is at what is considered contractionary levels, with rates well above the assumed neutral real interest rate that balances the economy in the long run.
This could mean the Fed will leave rates unchanged and give monetary policy time to take effect. It may even become politically expedient in 2024, given the desire to avoid an election year recession if possible.
However, despite the fact that rates have peaked and will remain at the same level for a long period, we still believe that it is not worth taking a long position in a sharply inverted yield curve until we see a path to lower rates. . . At the moment, few people in Washington believe that this can happen in the next 6-9 months.
We believe that in the absence of a significant decline in the stock market, this requires a change in the unemployment rate to at least 4.5% and above, with inflation below 3% and falling to the target by 2%. As a result, we remain neutral and look for more tactical opportunities if prices rise in the coming days.
Discussions about US policy have highlighted the likelihood that neither Trump nor Biden will run in the upcoming election. However, in the case of the Republicans, this requires narrowing the field of candidates, since it takes a plurality, not a majority, to win the nomination.
As for the Democrats, Biden is expected to win the primary but could then be persuaded to resign next summer for health reasons. In the national election, Trump is seen as the most likely winner, with outside candidates likely to take votes away from Biden.
Foreign policy will not be the main topic of the US elections, although among Republicans, Trump’s only political difference from others was his position on Ukraine. This may be the cause of a rupture within the party.
As a result, other candidates may also be forced to downplay support for Ukraine. Meanwhile, our feedback from Moscow reveals a troubling desire for an escalation of the war, making the road ahead in the region look painful. However, we expect the EU’s support for Kyiv to be unwavering and hope that the country will be able to emerge from its current difficulties as an EU member in the coming years.
Bond yields also hit new highs during the week and continue to underperform Treasuries. Meanwhile, the Japanese central bank is under constant pressure to let yields rise as its policies continue to weaken the yen.
In the last quarter, the big surprise in Japan’s GDP growth came from exports, although it’s surprising to see nominal growth picking up pace as inflation continues to pick up. From this point of view, keeping a short position on Japanese government bonds still looks like a good choice.
Elsewhere, risks to China continue to rise, although we don’t think Beijing can do anything to support the economy. The cancellation of the publication of economic data is a worrying sign that portends the possibility of political missteps in the coming months.
In many ways, China’s problems today may mirror those of Japan in the 1990s. From this perspective, we added a short position on the Chinese yuan, expecting the currency to continue to weaken, hitting a 15-year low this week.
Meanwhile, the unexpected rise in UK employment data could create additional problems for the Bank of England. She has been more specific lately in reporting her reactive function to upcoming meetings, focusing on private sector wage developments, labor market tensions and short-term service inflation to determine the next step.
The data this week has been mixed, but with another round of labor market and inflation data expected ahead of the September meeting of the Monetary Policy Committee (MPC), it is too early to conclude whether another 25 points are warranted. or more movement is needed. . The latter assumption is more difficult given that the MPC believes current rates are already in tight territory.
Markets are looking for rates to rise to 6% at the end of the year, although we tend to see Bailey and his colleagues becoming more dovish as all data on job growth and economic activity show signs of easing. We still believe that the pound is now overbought.
Look forward to
It seems to us that the market consensus is likely to be positioned as long-term in terms of duration and asset exposure to risk. A new yield high could be met with technical selling and could affect sentiment. As a result, we prefer to remain relatively cautious for the time being.
August is a month when the markets are quite illiquid and it’s not hard to imagine a price spike that would give more opportunities to break into more attractive market levels.