Blain’s Morning Porridge, 8th Nov 2023: If Nothing New Happens – What Can Stop The Bond Rally?
“Coming in on a wing and a prayer, though there’s one motor gone, we can still carry on…”
Bond Markets are a wonderful thing to behold in full rally mode, but expectations of a swift return to lower rates depend on Central Banks playing ball, and nothing else changing. Experience shows things change quickly re inflation, rates and markets!
OK! All right already… Sovereign Bond Markets are off to the races. No one waved a starting flag.. but tides and markets wait for no man. A 5% to 4.5% range on the benchmark 10-year Treasury Bond over three weeks is extraordinary.
It already looks like the Bond rally may have overshot, but markets are 90% convinced the US, UK and European Central Banks have hiked rates as high as they are going! (Caveat: unless.) Who cares the same central banks also loudly said rates will remain elevated for some time. Blah, blah, blah.. markets ain’t listening. What they heard is rates aren’t going higher. And then, Bank of England Economist Huw Pill said it’s not “unreasonable” to predict a cut next summer…. The Gilt market is pricing in 75 bp of cuts (to 4.5%) next year. Being a contrarian I listened to the next thing Pill said: “if nothing new has happened”.
We can discuss “nothing new” in a moment.
I’ve never quite grasped the point of forward guidance. Doesn’t matter if it’s the Fed, the Bank or the EBC… markets never listen for good reason.
- First, markets are not clever. They are just voting machines. They behave like food-obsessed Spaniels (for non-dog people; very silly, lovable English gun-dogs); they smell central banks have treats in their pockets…
- Second, smart traders are convinced the lagging effects of the steepest series of interest rates in history are becoming apparent across the economy as employment pressures weaken, corporate default rates edge higher, and recession becomes a clearer threat. That makes it highly unlikely central banks will resume hikes in the face of rising recessionary signals.
So, what happens next?
One of my favourite aircraft quotes of all time is from Chuck Yeager, the ultimate Right Stuff World War 2 Ace, the man who broke the sound barrier, who was still flying fast jets into his 90s. He said “A good landing is one you walk away from. An excellent landing is when you can still fly the plane the next day.” I commend his pithy comment to Central Bankers around the globe.
Each central bank is now on the glide path towards the runway – how soft the landing will be is now the critical thing. Will the economy still fly the day after?
The risk in the US looks least: the economy (our notional plane) has good momentum from robust growth, its stable as inflation falls, enabling the pilot (let’s call him Jay) to keep the nose up as the plane sinks towards the runway. On path.. nothing to distract him.. Oh, no, what’s that big orange blob? Thump.
In the UK the engines are a bit spluttery, it’s a bit bouncy and bits are falling off, the cabin staff are arguing about who gets the last few biscuits, but the pilot (Andy, plus his sidestick Huw) are keeping a stiff upper lip. They are both worried if they keep the plane level the economy will stall. If they push the nose down to pick up some airspeed, inflation will leap up to grab them, forcing them to hike again, catching them a chaotic series of jolts before the plane thumps down onto the runway, kangarooing in a sickening series of bumps with enough force to break something. Definitionally, not a soft landing.
In Europe… the cockpit is busy as the pilot (Chrissie) tries to herd her 27 co-pilots, each of them wanting something different. She’s watching the economy at stall speed, but can’t put the nose up, down, touching the ground. She is wondering just what kind of crater they might leave if the economy goes into a flat spin. No matter, ground control (in the guise of the IMF) just called to say they look fine.
What happens when these planes land? Which economy do you invest in?
Would you choose the US because its already the absolutely dominant stock market, global commodities and trade are dollarized, and it’s also a big self-contained internal economy with decent growth, demographics and oozing innovation? But it’s also fully priced. And it’s got a looming problem – elections in 2024 that might just further wipe off the gloss that makes the US economy look so bright and shiny to global investors.
The UK looks a tad forlorn at the moment. But nothing that can’t be buffed out or will look better after some T-Cut. There is about to be a change of inmates at Westminster Asylum with a new bunch promising they can fix everything by being good, communicating clearly, and demonstrating they actually know what they are doing… which is exactly what David Cameron said a couple of million years ago in 2010.
Europe is the interesting one. The IMF say inflation will moderate, and predict a soft landing. Its latest prediction is for 1.5% growth in 2024 rising to 2.1% in 2025, comfortably beating the UK at 0.6% next year! It warns Europe to tame inflation through restrictive monetary policy for the medium term in order to support that expected growth… oh, and by the way, improve productivity, get Europeans back to working longer and harder. So same old problems…
But I can’t help but wonder about BoE economist Huw Pill’s throw away line about “if nothing new has happened”. I suspect if there are threats to the global bond rally, then they are already in plain sight. They will be factors that challenge blithe assumptions the war on inflation has been “clearly” won. I warned earlier this week that most long periods of stagflation (like the 1970s) saw a series of inflation peaks – not just one.
This time the actual inflation shock was Energy. It was just a trigger. Outwardly the causes of the Energy price shock (like over-reliance on Russian power) have been swiftly addressed, but other sources of inflation – many secondarily triggered by Ukraine crisis – have also became apparent; including supply chain vulnerability and food sustainability. The triple whammy of energy, utility and food inflation, and crashing discretionary consumer spending have triggered a new wage demand cycle (see Inflation: Dead or Resting), and other cost push factors which are still creeping through the economy.
Persistent inflation from wages and product cost, plus the engineered slowdown caused by hking interest rates still run a significant stagflationary risk. But no point telling the bond market that… they are anticipating a further rally to come. Someone call the spaniels to heel.. (This morning’s photo is not a Spaniel – but a gorgeous Cockapoo named DeeJay. I am his butler and gofer.)
Let’s see what happens.. What I can promise is it won’t be what markets expect.
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Out of time, and lots to do today…
Bill Blain
Market Strategist, Alternative Assets and Author of the Morning Porridge
Love the pilot analogies and only ask if you could describe Japan Air Lines under
Captain Ueda and the likely landing.
Many Thanks.