Iggo's insight: a view from the bond market - commentary from Chris Iggo, AXA IM - Enjoy The Silence
Inflation is gradually rising and economic data, on the whole, is very positive. Investor focus is on politics but it is important to understand that the Federal Reserve (Fed) needs to raise interest rates through this year. The risk free rate will go up and that will raise questions about the relative value of credit and equities somewhere down the line. But not now. Momentum is strong, risky assets can still perform well and the reflation trade should prevail for a while. It’s hard to say we face an imminent monetary squeeze when the Fed Funds rate is just 0.75%. Stick with credit and inflation spreads and enjoy the longer days.
I must admit I have great respect for those analysts with sufficient patience to concentrate on what is being discussed at events such as Janet Yellen’s semi-annual Congressional testimonies. The performance the Chair of the Board of Governors gave this week was very much in character which means that you had to look very hard for any new information or guidance for markets. What bond traders are focused on is how many interest rate hikes are in the pipeline for this year and what are the odds of the next being announced at the Federal Open Market Committee (FOMC) meeting on March 15th. According to Bloomberg, market pricing only puts a 36% chance of the Fed Funds rate being increased to 1.0% at that meeting and instead gives a greater chance of the FOMC waiting until June (77.1%). If anything, Yellen left the door open for a rate hike at either meeting and the most telling message, in my opinion, was that there is a real risk of falling behind the curve – “waiting too long to tighten would be unwise”. She also suggested that the economy was operating at full employment and that the Federal Reserve (Fed) sees the economy making progress towards its longer term goals (meaning inflation around 2%). The political backdrop to the Congressional presentations is, of course, a new Administration and the Fed chair was quizzed on a number of policies that could be introduced by President Trump and what impact they might have on the economy (immigration, fiscal policy, bank deregulation). Diplomacy is required in answering those types of questions but the main message was rate hikes are coming and the process of monetary policy normalisation is underway and will continue. Yellen also suggested that the Fed may have more to say later this year on how it ultimately unwinds its balance sheet holdings of Treasury and other securities.
Deflation, what’s that?
Many in the bond market would take the view that rates need to move higher in line with the increase in inflation. This week we got inflation data from the US and the UK. In the States, the consumer price inflation rate moved up to 2.5%, its highest point since 2012. It is likely to go higher still. If monthly increases in the consumer price index this year equate to the average of the last six months then the year-on-year inflation rate will be close to 3.75% by December, almost matching the inflation peak that was registered in 2011. If inflation is sustained above 2% this means that, at current levels, real short term interest rates are very negative (the 2 year note only yields 1.2% today), which is probably not appropriate for much longer for an economy that is operating at full capacity. Moreover, regular economic indicators suggest that momentum might even be accelerating. The Philadelphia Fed survey of manufacturing firms for January was very strong and has only been stronger on a couple of occasions in the early 1970s and early 1980s. The NFIB Small Business Optimism index remained at a very high level in January after rocketing higher following the election, while the New York Fed’s survey of manufacturing in the Empire State also suggested that the manufacturing sector in the US is on a mini-cyclical boom. It is likely that animal spirits amongst corporate managers are being kindled by talks of tax reform and the pro-business rhetoric coming from the White House.
The UK inflation rate is not quite as high as the US rate yet but is heading in the same direction and recent announcements of price rises by Apple and Microsoft, as well as energy companies in the UK, point to a prolonged period of rising headline inflation in the UK. It’s not being driven by domestic costs but by imported inflation due to the decline in the external value of the pound since the Brexit referendum. Sterling’s trade weighted index is down 10% since then so it makes sense that things the UK imports are going to be more expensive. In January the inflation rate increased to 1.8% and it is not unreasonable, in my opinion, to think about it hitting the 3.0% level that inflation was just short of in 2013. In the US there is evidence that wages are also increasing in line with inflation and the tightness of the labour market is starting to be reflected in increased household income. That does not appear to be the same situation in the UK, despite the unemployment rate being very low. In the January labour market report most of the details pointed to a strong jobs market – less people claiming for unemployment benefit, a 37,000 increase in the number of jobs created in the 3 month period to December and the unemployment rate remaining at 4.8%. Yet average weekly earnings growth actually slipped to 2.6% in December from 2.8% before. If that is a true reflection of what is happening it means that real incomes are getting squeezed by higher inflation, which is not great for consumer confidence and spending (the fall in retail sales in January might be a sign of that already). This could prove to be a challenge for the Bank of England in terms of how high it is prepared to let inflation rise before interest rates are increased. Market pricing suggests a less than 20% chance of a rate hike this year but if inflation does rise towards 3% those odds are likely to change.
The macro backdrop in early 2017 has been very supportive of the reflation strategy in fixed income. That has meant favouring exposure to credit, especially high yield, and to inflation linked securities at the expense of pure government bonds. For example, the US inflation linked bond index has outperformed the equivalent Treasury index by 64 basis points (bps) while in the UK the outperformance has been a massive 2.9%. On the credit side, all the core credit indices have outperformed their respective government curves even with significant new issuance activity, especially in the US market. I suspect that if there is more of a sense in the market that the Fed will take a pass on a March hike, then bond markets will continue to perform well – government yields could remain stable with credit spreads tightening further. If the Fed does raise rates in March there could be some short-term volatility, but the driver would be more confidence on the economy and the continuation of conditions that allow risky assets to outperform.
Quiet, it’s so quiet
Whether it is because of half-term in the UK or whether it is because most investors are happily positioned, trading volumes and volatility measures have been very low. For the moment investors seem to be more amused by Donald Trump’s “fine-tuned machine” than feeling necessary to take a more cautious investment stance. The big macro policy announcements are still ahead of us but the expectations are bullish and that has some self-reinforcing tendencies. Optimism generated by higher equity prices makes investors more bullish. This can also affect investment spending by companies and consumption. Yet any alert investor knows that there are uncertainties ahead. The election process in the Netherlands is just getting underway, parallel with what is happening in France. When we look to Washington it could be said that the Administration is only one more failed nomination away from being seen as chaotic and ineffective. On the geo-political front I think it is not clear what Trump backing away from the “two-state solution” in the Middle East will mean for Arab-Israeli relations and who the heck knows what North Korea is up to? But are these reasons to go mega-cautious just now? Probably not. It is not as if the credit market has been euphoric (spreads are not at all-time lows like equities are at all-time highs). The Fed will raise rates and government bonds will offer better entry points at some stage. After all, when the risk-off moment comes you want duration and better to buy Treasuries with a yield of 3% than one of 2%.
Spring is sprung
Maybe we should just enjoy the calm. Spring is coming, the football season is entering the business end. There were some great and, arguably, surprising results in the Champions League this week. The Six Nations has been very entertaining so far and England are looking unstoppable. Up North my teams are doing well with United in one cup final, on track for two more potentially, and poised to take one of the top four places in the League. Meanwhile, the Owls look as they will be in the post-season Championship play-offs again. So I will keep on clipping the coupon in the markets and enjoying the sport.
Have a great weekend!
CIO Fixed Income, AXA Investment Managers
All data sourced by AXA IM as at 17 February 2017.
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