La Française: Correction, and after rebound

November 14, 2023

Interest rates continued to rise sharply in October, especially in the United States and Anglo-Saxon countries, with the long end of the curve suffering greatly as well as a significant switch of the curves.

These movement can be partly explained by a US economy that is still in good shape, with annualised growth of 4.9% in the third quarter (well ahead of economists' forecasts) and a job market that is showing few signs of running out of steam. The other reasons for this bond correction are the same as in September: significant amounts of issues to digest, term premiums still low and quantitative tightening programmes still ongoing.

Logically, risky assets reacted negatively to the continuing rise in real interest rates, with equity markets losing between 2 and 5% over the month and credit assets behaving similarly.

However, these trends have not been without consequences. In particular, central banks were very vocal about raising long-term rates, indicating that this was helping to tighten financial conditions and therefore reducing the need for them to continue their cycle of rate hikes. This is true in United States and Europe, except in case of any significant upward surprises with regard to inflation in the coming months.

October was also marked by the conflict in the Middle East, which seems highly unlikely to end in the short term. For the moment, there are no consequences for the markets, and this will probably remain the case as long as the conflict does not spread. History teaches us that the impact of this type of event is, in most cases, extremely weak, except in case of a significant impact on commodities. With war still raging between Ukraine and Russia, this is the start of a second major armed conflict in a potentially destabilizing area for energy commodities.

The beginning of November was marked by events that triggered a bond rally of rare intensity, sweeping through all asset classes:

• an announcement on 1 November of the composition of the US Treasury's QRA programme, with lower overall issuance than market expectations.
• ISM Manufacturing very disappointing at 46.7.
• FOMC report that does not reveal much, but seen as reassuring by the market.
• Job creation figures below expectations (but potentially difficult to read because of the heavy strikes in October).

A welcome rebound, but the macroeconomic situation remains uncertain.

It is logical that the market needs to breathe after the very sharp rise in interest rates, and it also makes sense for all the other markets to follow suit. But the scale and speed of the movement are perplexing. The market scenario seems to have reverted to an ideal soft landing, where inflation gradually returns to close to the central banks' target, with weak growth but no recession. This is not impossible, of course, but in our view, it is not the most likely scenario.

The most probable scenario is persistent inflation of around 3-4%, as long as wage inflation remains so high. The disappointing NFP data released in early November should not overshadow the other employment figures, which continue to paint a generally reassuring picture (claims, Jolts, Challenger, etc.). Even in the Eurozone, where the macroeconomic situation remains depressing, persistent wage pressures are still at the heart of the ECB's concerns. Isabelle Schnabel reminded us of this at the beginning of November with wage negotiations still leading to substantial pay rises.

All this should force central banks to keep interest rates high for longer than the market currently expects, if the job market does not collapse, which does not look like happening any time soon. And, at the risk of repeating ourselves, the budgetary dynamics of governments will have a major impact on the resilience of the economy and the labour market to rate rises.

Concerning this last point, October saw countries pursue stimulus strategies that will only prolong the cycle: China ($140 bn), Japan ($113 bn) and the United States ($100 bn, not yet approved, in connection with the various conflicts).

Caution is therefore still the order of the day, especially after the very violent rebound at the beginning of November, the geopolitical risks (in particular, regarding oil and gas) and a earning season which, for the time being, is not very reassuring, either in terms of sales or guidance.

November/December outlook

We are maintaining cautious risk positioning despite historically positive seasonality. The volatility of the long end of the rates curve remains very high (with curves still inverted despite the recent movement) which leads us to maintain a preference for the short end of the curve. Equity markets do not yet seem to reflect the restrictive monetary policies of Central Banks and the risks will weight on margins, and hence earnings, in the quarters ahead.