La Française: Another sharp rise in rates, prompting prudence

October 10, 2023

September 2023 will be remembered for the sharp rise in rates across all bond markets. With the 10-year US up 46 bps, the 10-year German up 33 bps and the 10-year Italian up 63 bps, these fluctuations are very impressive, with the slopes of the curves becoming significantly inverted.

It should also be noted that this is happening without any notable change in inflation forecasts, which is also generating very strong fluctuations in real interest rates. US and German real interest rates are now at their highest levels since 2008 and 2011 respectively.

In this highly volatile interest rate environment, equity markets fell by 3 to 5%, which is logical given the movement in real interest rates, but credit indices held up very well! The Bloomberg HY Euro index (LP01TREU Index) ended the month in positive territory, up 0.41%.

One of the key instigators of the rate hikes is evidently the central banks. The Fed recently stiffened its hawkish stance with an announcement, which, through its dot plot, raised its rate expectations for the end of 2024 and 2025, and increased its growth forecasts.

No help came from the ECB either, with a rate hike that was only partially anticipated by the markets and a deceptively dovish announcement. In fact, after Ms Lagarde hinted that this was the last rate hike, it was not long before some dissenting voices were heard within the ECB committee.

But other factors are also playing a structural role in pushing up rates on the long end of the curve, as we pointed out in our 'back to business' communications at the end of August, such as: term premiums remain very low coupled with a gradual reduction in central bank balance sheets, as well as significant forthcoming issues and slopes that are still very inverted. Not to mention budget deficits that are still very high and are likely to remain so next year.

This last point will undoubtedly be the most important over the coming years and the most difficult to forecast. If governments continue to pursue expansionary fiscal policies, it will probably be difficult to bring inflation back down to around 2%. As Milton Friedman said, inflation is always a political phenomenon.

Prudence maintained in the face of market volatility

However, high volatility was not just restricted to the bond markets. The dollar and the price of a barrel of oil continue to rise, which is not good news for global growth. The rise in oil prices will also make the short-term inflation trajectory more challenging, with the end of negative base effects and potential second-tier effects that remain difficult to forecast. The dollar is proving particularly strong against the yen, increasing the pressure on the Bank of Japan, which is having to combat both the depreciation of its currency and the rise in Japanese long-term interest rates.

The macroeconomic news did not upset the balance in September. The PMIs are not changing significantly, the IFO neither, nor across the Atlantic in terms of key business data. Employment markets also remain fairly stable and are still very resilient.

In short, we see no reason to change our defensive asset allocation, with a strong preference for the short end of the curve, whatever the nature of the bond assets. We also favour index-linked bonds relative to nominal bonds, for reasons of both carry and hedging in the case of a second wave of inflation. On the equity side, we are also adopting a defensive stance, mainly because of the sharp rise in real interest rates.

October/November outlook

The long parts of the curve are in a repricing phase, which still calls for great caution. The rise in the dollar and oil prices further amplifies current uncertainties as to whether inflation will return to central bank targets. In short, general caution.