Markets took fright of the worsening growth outlook last week. Despite more hawkish noises from the US Federal Reserve, we saw a rally in bonds on Friday, taking 10-year US yields away from the 3% level that looked likely earlier in the week.
In the UK 10-year yields had moved above 2% but are now trading near 1.85% whilst in France the re-election of President Macron was widely discounted and 10-year yields just echoed the move in other European bond markets.
The victory of President Macron represents continuity in European politics but should not disguise the massive disillusionment with mainstream parties in France. The traditional centre right and centre left political coalitions that have dominated France for most of the post-war period were devastated. This maybe a precursor to more unstable European politics as escalating price pressures, cultural divisions, and slow growth cause questions to be asked about the best political solutions.
So why are risk markets getting more agitated? Rising government yields are one answer, with US 10-year rates doubling in five months. Real rates have also moved, as illustrated by the UK 30-year yield, which has risen by 90bps in that period. But there is also a sense that growth expectations are coming down, not just as a result of monetary policy tightening but also concerns about how China is dealing with Covid.
Compared with Western societies, China has had a ‘good’ crisis with much lower rates of hospitalisation and death than seen in the US and Europe. But this has come at a cost to economic output and we are now faced with the prospect of more wide-ranging lockdowns. Despite the high level of state command seen in many aspects of Chinese society, vaccination rates among the elderly remain relatively low. This suggests that the Covid impact will be drawn out in China, with consequent economic disruption to supply chains and consumer demand.
Credit markets continued to weaken, with sterling investment grade spreads widening by 5bps. High yield markets were a bit wider but spreads are still below the levels of early March. The big picture has not changed a lot and I continue to prefer credit to government bonds. Short duration strategies discount a continuous period of monetary policy tightening over the next 12 months. What we are seeing is a re-appraisal, with investors trying to determine the tipping point at which counter-inflation policies push economies into slow down or even recession.
At the moment inflation concerns drive policies but if I am right, we should see headline inflation rates coming down in 2023. I don’t think this is the time to get too bearish on bonds.
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