The US economy is in a more robust state compared to Europe and the UK. While we’re seeing signs of a slowdown, the pace is very gradual. There are two key things to note here:
1. The full impact of the 11 rate hikes made through 2022 and 2023 is yet to come through.
2. The increase in the term premium of the US Treasury market has meant that we’re seeing a much tighter financial environment anyway.
The term premium has increased due to the inherent uncertainty in the market; investors need a financial cushion to compensate for owning longer-duration assets, which are more exposed to interest rate fluctuations and upticks in inflation. We felt that 5% was a fair premium and we’ve seen the number bounce around this level for a while, reflecting the Federal Reserve’s (Fed) efforts to manage expectations and keep a relatively hawkish viewpoint.
Having said that, term premium rallied at the end of last week in response to the Federal Open Market’s Committee meeting on Thursday, as Powell’s messaging was perceived as more dovish. The Fed is now managing a fine balancing act to keep the figure in check.
We expect the US consumer to start to fade from here, as Covid cash handouts are well and truly over and personal savings have been run down, in part due to a bout of giddy revenge spending. Consumers are turning their attention to high inflation and a softening in wages (despite some of the bumper pay deals we’ve seen in the auto sector). We don’t expect to see too much stress this side of Christmas, but indications of a slowdown are coming through, with rates expected to remain on hold and the Treasury market trading around the current range.
In Europe, any ‘higher for longer’ rhetoric has lost all credibility. The manufacturing sector is clearly in recession, and in our view, the broader economy is too, meaning rates can’t go up any further and we’d expect to see the first cut ahead of any movement in the US. We may even see individual countries with more economic stress, like Italy, clamouring for central rates to be cut. While Europe was at 4.3% inflation in September — some way away from the 2% target — we’re expecting to see a rapid decline in the figure over the next couple of months as consumer demand evaporates.
Dogmatically keeping rates high while that number comes down would only serve to cause a hard recession. Gradually trimming rates in tandem with an easing in inflation seems like a more sensible approach, to us.
The UK consumer is facing a similar struggle – despite wage inflation, the cost of living has exploded and the economy is showing signs of entering recession. We think any further rate hikes would be foolish. What seems more plausible is rates remaining on hold until the summer, before the first round of cuts in the second half of 2024. As with Europe, we’re expecting to see UK inflation come down rapidly as the full impact of rate hikes cycles through, and this will put Bailey under pressure to cut.
Positioning
We’ve been active on duration hedging as the term premium effect wasn’t something we’d anticipated. We’d initially felt that 4.5% was fair value on 10-year Treasuries, but the market hadn’t fully priced the supply issue (it was a little less than expected), so needed to adjust to reflect this, alongside the consensus view shifting to rates having peaked. We took all the duration hedges off, positioning long duration across all the strategies. The subsequent 5.10% to 4.80% rally on the US 10-yr therefore benefited our long-duration stance.
We also have a credit hedge on in anticipation of economic slowdown in the US, which is yet to deliver, but the duration effect has outweighed the negative impact.
We’re expecting to see the economic environment show signs of slowing, and Friday’s below-forecast non-farm payroll number confirms, to our mind, that the hiking cycle is over for the US.
We’re also expecting the November CPI number, which comes out in December, to be notably weaker, supporting the downtrend in inflation. This will likely result in a repricing of credit risk, and we think the best positioning remains long US duration due to the convexity. Similarly in Europe, we like duration over credit, reflecting our view that the economic landscape is notably weaker than in the US.
