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Our views 29 April 2024

JP’s Journal: Avoiding the tipping point

5 min read

The US economy grew at a slower rate than expected in the first quarter, at an annualised 1.6%. Investors reacted by pushing down yields as they focused on the shortfall. However, two opposing forces drove 10-year yields above 4.7%.

First, the breakdown of the GDP data showed that consumer and business activity were healthy. Consumer spending grew at a decent 2.5% and business investment increased by 2.9%, while housing investment was especially robust. The main factors that dragged down first quarter growth were net exports and inventories, both of which can fluctuate a lot. True, the US savings rate declined, as real disposable income only grew by 1.2% but the overall picture was more positive than the headline number. The second force was high inflation as measured by the core Personal Consumption Expenditures Price Index (PCE), a comprehensive measure of underlying consumer inflation. Here the result was clearly disappointing, with the index rising to 3.7%, compared to a forecast of 3.4%, showing the stickiness of inflation despite some easing in economic momentum. Market nerves were calmed somewhat by a later release of monthly PCE figures which were in line with expectations.

Whichever way they are looked at, last week’s US inflation readings were stronger than consistent with a 2% inflation target. This supports the view that the Federal Reserve (Fed) will stay put for the time being, hence a further easing back in rate cut expectations. Four months ago, the Fed Funds rate was expected to be around 3.75% by the end of 2024; it is now priced at 4.5%. Likewise, 10-year US Treasury yields that dropped from 5% to 3.8% in two months at the end of 2023 are now approaching 4.7%. Not surprisingly, real yields have also increased, with 20-year rates back to 2.4%. But implied inflation, which is calculated by the gap between nominal and real rates, has risen due to the worry about the persistence of disinflation. The 20-year implied inflation rate is now at 2.5%, 20bps above the level seen in December 2023. The same story applies to the UK. 10-year yields ended above 4.3%, 10bps higher on the week and 90bps above the December low. Real yields have trended higher whilst implied inflation, at the 20-year point, is 25bps higher than in mid-January. Credit markets moved with the change in underlying government yields and there was little change in either investment grade or high yield spreads.   

In the UK, we appear to have a government in waiting, with policy initiatives from the main opposition party gaining more attention from the media than those of the current government. Last week saw a proposal from Labour that will bring the UK rail system under state ownership. This may not be as radical as it sounds, given that several franchises are currently under effective government control, and the plan is to bring the rest under Great British Railways over a five-year period. But it is a good reminder that more spending is likely to fall under the responsibility of the state in the coming years – even without a change of government. Welfare, health, and social care spending are all on an upward trajectory. Unless there is a gear shift in productivity or a move towards higher taxes, this implies more public debt. Debt financing is another cost that is moving up.

We are not there yet, but investors will start to baulk at the size of global debt issuance that has to be absorbed. This must mean higher real yields in the long term which in itself will make growth more difficult. Governments will be acutely aware that there is a tipping point around debt and will strive to avoid entering a vicious circle of waning investor confidence, higher yields, low growth, and burgeoning debt costs. To placate investors and keeping the electorate happy will be a challenge. Getting on the wrong side of either will not be pleasant.


This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.