What happened in the markets this week
Everything important that happened for the markets in the week that is ending. The Takeaway by Mark Dowding, Fixed Income CIO, RBC BlueBay AM
Weaker ISM and JOLTS data on US jobs added have helped push Treasury yields lower over the past week. With longer-dated bonds leading the rally, U.S. yields reversed market movements in the second half of May. As a result, futures are now pricing in a 75% chance of a Fed cut by September.
Some anecdotal evidence seems to suggest a weakening of consumer-led economic activity, and in light of this the Atlanta Fed's forecast for second-quarter growth has fallen from around 3.5% to 1.8% in the last two quarters. weeks. However, other indicators remain optimistic. The labor market report, to be released today, is expected to show that payrolls are growing at a rapid pace. Meanwhile, ISM services data was strong and the S&P stood at record levels, thanks to the continued climb of Nvidia stock.
Furthermore, any rate reduction path will depend on inflation. Despite the improvement in the consumer price index, any easing policy will depend on a new downward trend in prices in the coming months and it seems premature to take this outcome for granted. From this perspective, any further rate rally will have to be contingent on positive May CPI data arriving in the middle of next week.
As a result, if yields were to fall further prior to this event, it could be that the balance of risks favors reducing overall duration exposure. That said, we continue to believe 2-year Treasuries are close to fair value in a range of 4.75% to 5.0%, absent further information.
In the Eurozone, Lagarde announced an interest rate cut of 25 bps, bringing the deposit rate to 3.75%. This was the first interest rate cut since 2019 and there is a possibility that rates will fall further in the second half of the year. However, the ECB's eagerness to cut rates will depend on incoming data, as well as being influenced by actions taken by the Fed overseas.
The direction of fiscal policy could also weigh on the ECB's decisions. In this regard, by the September meeting, the direction of travel of the new European Parliament should be more clear. For now, Bunds are close to fair value levels and we do not have strong conviction on Eurozone fixed income assets.
We remain skeptical that the UK will follow the Eurozone's lead and cut rates any time soon. There are still a couple of weeks to go until the next Bank of England meeting, before which the May CPI will be published. However, we continue to believe that the inflation trajectory in the UK is more problematic than elsewhere.
Against this backdrop, we expect the October OFGEM energy price ceiling to see a move of -4% year-on-year, compared to estimates of close to -20% currently embedded in the Bank of England's thinking. Although oil prices have moderated recently, we continue to expect UK inflation to rise over the summer and into the second half of the year.
Meanwhile, the arrival of Nigel Farage as leader of the Reform UK party has added interest to a general election that has always looked like a coronation procession for Labour, under the leadership of Keir Starmer.
If Reform UK gains momentum, it is not far-fetched to think it could match or overtake the Conservatives in the polls, reflecting the political class's underlying disenchantment with the establishment. If this were to happen, the implosion of the Conservative Party could easily accelerate, as the party would turn against itself, even before the election. In this scenario, the idea of a reconstruction of the political landscape after the elections becomes more likely.
If that were the case, one would think that Farage would be able to take on the role of leader of the Conservative Party, given that there may be few other credible candidates left in Westminster.
Next week's Bank of Japan meeting will be closely watched. Rumors have mounted in recent weeks that Ueda will announce a substantial reduction in bond purchases to help curb pressure on the yen. However, more dovish comments in recent days have cast doubt on this assumption.
We continue to think it is wrong for the BoJ to actively expand its balance sheet as part of QE, at a time when other central banks are going in the opposite direction. However, the BoJ hopes that the US economy will cool and rates will fall, thus reducing pressure on the BoJ to rush into policy measures. However, national data continues to point to growing inflationary pressure and an upward shift in inflation expectations.
Lower US yields over the past week have helped take some pressure off the yen, but if this trend were to reverse, the Japanese currency would be vulnerable if Ueda sounds too dovish next week. If the BoJ were to stop buying 10-year bonds, we think yields should settle slightly above 1.25%, compared to the valuation of longer-dated 30-year bonds, which have reached 2.25%.
Emerging markets experienced some volatility last week, with election results in South Africa and Mexico throwing up some surprises. The ANC's performance in South Africa was much worse than expected, and this led to negotiations over a potential coalition. An alliance with the DA party would be seen as favorable by investors, while an alternative alliance with the more radical EFF would represent a very negative outcome.
As the ANC grapples with its internal choices, several competing considerations are at play and the outlook is still uncertain. Ultimately, we continue to hope for a constructive outcome. With long-term yields of 11.5% and inflation of 4%, we see a lot of value in South African Gilts, should that happen. However, in the short term, we are happy to hold these bonds and hedge some of the risk with a short rand position, waiting for more clarity.
Meanwhile, Claudia Sheinbaum's margin of victory in Mexico opens the door to a more fiscally expansive redistribution program. Although Sheinbaum's victory was widely expected, the fact that the Morena party achieved the majority needed to make constitutional changes took investors by surprise. As a result, the peso fell 4% at the start of the week, only to recover somewhat on reassurances that any changes made would mitigate the impact on Mexico's deficit or broader macro picture.
Elsewhere, India's elections saw Modi's party win the most seats, although it had to rely on smaller coalition parties to gain a majority in Parliament.
This past week has reminded us how politics and policies can move markets, and how political outcomes can sometimes be relatively difficult to model with much precision before the event, despite improvements in polling methodologies.
By contrast, credit markets remain relatively calm, with spreads relatively stable. New issues continue to see strong demand, although syndicate teams are confident they can squeeze any premium out of the prices offered. That said, the push to tighten spreads appears to have lost momentum, while valuations are hitting a small wall. Financial stocks also had a week of profit-taking, following a recent string of strong relative performances.
LOOKING AT THE FUTURE
Election polls in the United States remain relatively close nationally, although in swing states the favorite appears to be Trump, with less than six months to go until Election Day.
Meanwhile, a Wall Street Journal article questioning Biden's cognitive abilities continued to undermine the president's standing, with voters questioning his ability to complete a four-year term. Sen. Shelley Moore Capito seemed to capture the mood, noting that a couple of years ago she found Biden “sharp as a tack.” When asked whether this characterization was still valid, she noted that this was debatable. Others were much less respectful and polite in their comments. Furthermore, it is difficult to see what the President can do to change this general assessment, given that he is not destined to get any younger.
With CPI, payroll and FOMC reports coming in the next few days, next week promises to be an interesting one for financial markets. We believed that price action would be limited for some time to come, until it becomes more evident whether inflation is falling again and whether we will see interest rate cuts as a result, or whether the current level of monetary restriction may have to be maintained throughout the second half of the year.
It seems unlikely to us that the FOMC will decide to move interest rates after September, before the November elections. This means that the outcome of the September FOMC could be crucial and data from the next two months should help determine it.
Keeping an open mind and being ready to take a stand if markets get ahead of themselves, in either direction, seems like the right path to follow from here on out. Despite the rise in Treasury yields this year, the recovery in equity and credit markets means that financial condition indices are at slightly more favorable levels than the average level that has prevailed, based on the last 10 or 20 years of data.
Against this backdrop, if stocks and credit continue to perform well over the summer, this will continue to mitigate the need for Fed intervention.
Of course, a large portion of the stock rally is solely a function of Nvidia's own price movements. It appears the AI boom is in full swing, and as data centers continue to increase capacity, it's conceivable that models will consume all the information available on the Internet by the end of next year.
At that point, the desire to add capacity may slow down, but until then it seems difficult to stand still in the face of a moving train. Plus, with robots now investing, one wonders how AI is programmed to continue wanting to buy stocks on its own. There will certainly be many unintended consequences of this development, which will impact all of our lives in due course. Indeed, with US voters having to choose between an increasingly fragile Biden and a doomed Trump, perhaps a robot in the White House wouldn't be a bad thing….
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/cosa-e-successo-nei-mercati-questa-settimana/ on Sat, 08 Jun 2024 05:33:32 +0000.