BlueBay AM: Markets in mourning over inflation

September 16, 2022

By Mark Dowding, CIO at BlueBay Asset Management

Treasury yields jumped in the wake of a strong US CPI report this week, leading to an abrupt reversal in risk assets. With core prices rising by 6.3% in August (from 5.9% the month before), this is seen as pressuring the Fed to continue to move in a more hawkish direction in the coming months, with a cumulative 200bp in rate hikes now priced across the next three policy meetings.

This trajectory would see Fed Funds at 4.25% by the start of 2023, leaving policy rates decisively within ‘restrictive’ territory, relative to a perceived neutral long-term rate below 3%. The implication is that this should act to slow growth and dampen inflation pressures. In light of this, it appears that we are now discounting a policy path that may mean a modest recession has become the base case for 2023.

In the coming week we see the FOMC delivering a 75bp hike with a hawkish narrative, suggesting a further 75bp move to follow in November. Ultimately, the trajectory of inflation will be what determines Fed behaviour in the coming months, and with economic activity remaining robust for the time being, there seems little need for the FOMC to change tack for the time being.

However, we do still expect to see better inflation news over the next few months. With Eurodollar futures discounting a peak in rates at 4.6%, we think that any move higher from here pushes valuations into cheap territory, even if we doubt that longer-dated Treasuries look that interesting below 3.75% on 10-year notes.

Eurozone yields took their lead from the US over the past several days. In the wake of the hawkish ECB meeting, bund yields have matched their highs last seen in June. Nevertheless, German yields remain substantially below the forward trajectory that is discounted in euro policy rates, with the repo rate projected to reach 2.5% by next spring.

Arguably, German yields are artificially rich, due to a widening of swap spreads, in the wake of a squeeze on German collateral. Steps taken by the ECB last week have been designed to ease this, but markets continue to see these steps as insufficient.

On the periphery, Italian spreads have been relatively stable notwithstanding a more challenging backdrop for risk assets and higher European yields. To date, representatives we have been hearing from in Georgia Meloni’s Fratelli d’Italia, have managed to sound relatively responsible in terms of their intentions. They have sought to mark a clear distinction between themselves and those from Salvini’s Lega grouping, in what will almost certainly be the new coalition, along with Berlusconi’s Forza Italia. 

Given that many investors have had a very bearish assessment of BTPs in the run up to the election, the bar may be relatively low in order for Meloni to outperform expectations. This means that there is a risk of a squeeze tighter in spreads in the wake of the election, even if Italian credit fundamentals continue to look materially challenged.

We are happy adopting a flat stance for now, more inclined to sell strength on a squeeze tighter and better buyers, should 10-year spreads approach 300bp in the next several months.

In the UK, the nation’s focus has been away from developments in financial markets. However, robust labour market data may represent a warning that inflation could be a more persistent phenomena in the UK than is the case elsewhere. Nevertheless, we are inclined to think that the BoE will announce a 50bp rate hike in the week ahead. Markets have moved to expect 200bp of hikes from the BoE across the next three meetings, mirroring the trajectory for the Federal Reserve.

However, we sense that Bailey and members of the MPC have a more dovish bias and believe that prior tightening of monetary policy and a slowing economy mean that they won’t need to hike as quickly as markets suggest. In this context, we think that short-dated SONIA contracts for the end of 2022 appear cheap, even as we see room for gilt yields to continue to rise over the medium term.

Elsewhere, events in Ukraine have been garnering increased attention over the past several days.  The Ukrainian advance in Kharkiv Oblast has been a humbling defeat for the Russian army. This has led commentators in Moscow to voice doubts whether the war can really be won. This could lead to a more rapid push for peace, though similarly it could risk further escalation from Putin, if he concludes that his own survival is in peril, should his ambitions in Ukraine be seen to fail.

A mass mobilisation or a nuclear escalation remain extreme risks, but events of the past few days have seen the situation morph from more of a predictable stalemate, into something which may be much harder to foresee. Ultimately, the course this takes will be determined by Putin and those around him at this point. Though given how negative sentiment has been with respect to the war, a sudden cessation of hostilities could easily see a rapid transformation in the investment climate.

The strength in US CPI saw the dollar post renewed gains over the past week, with the greenback recording gains relative to Europe and currencies in emerging markets.

Meanwhile, the yen was supported by the threat of policy action. We are sceptical that direct intervention will have anything more than a temporary effect, unless it is accompanied by a change to BoJ policy. To date, the BoJ has done little to suggest that it is even contemplating this. However, as shared previously, maintaining a currency peg or controlling yields, requires that any policy change comes out of the blue, and is not pre-announced.

We expect next week’s Japan inflation data to move higher and there may be a chance for the BoJ to adjust its policy on Thursday. Failure to do this may prompt a further round of yen weakness to 150, then 160 versus the dollar and even higher. In this context, the costs of maintaining Yield Curve Control (YCC) is now starting to outweigh the benefits.

Credit markets came under pressure as equity markets dropped and volatility indicators moved high during the week. Confidence remains shaky. Although spreads in Europe appear to have discounted a mild recession, the outlook could deteriorate further if efforts to conserve energy fail to prevent supply rationing.

Meanwhile, in the US, absolute yield levels in asset classes such as high yield are attracting some buying above 8%. However, prospects for rising defaults if the economy does tip into recession, are likely to keep the risk premia elevated. Emerging markets tracked other markets during the past week, but we continue to see divergent performance between food and commodity importers and exporters.

Looking ahead

We continue to reflect on a theme of uncertainty. A better inflation print, which may have reinforced the notion that CPI was on a downward trajectory and that a peak in Fed rates was within sight could have created a more constructive backdrop for rates and spreads, but for now, this was not to be. We think it makes sense to be patient.

We think that better inflation news will be on its way, but for now it is prudent to take less risk and look to add exposures on the long (or the short) side, if it appears as if prices have materially overshot. 

Markets are currently in mourning over inflation, but there will be a time to re-engage in the weeks to come. Otherwise, on a lighter note, Spurs made headlines as first the team to lose a match under King Charles III. Though by all accounts, our new monarch is something of a Burnley fan, so it seems unlikely he would have been too upset by that...