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Our views 06 February 2023

JP’s Journal: Spring is coming – but beware of hard frosts

5 min read

There was a smell of spring in the air last week. Snowdrops and crocuses are out and there is a growing sense that the worst of winter is behind us.

Markets felt the same way and although central banks delivered what was expected, the response indicated that investors were sensing a turn for the better. The Federal Reserve (Fed) was the first off the blocks, delivering a 25bps hike, taking the target range to 4.50-4.75%. But it was talk of disinflation from Jay Powell (Chairman of the Fed) that sparked a rally in US treasuries, which overrode some of his more hawkish comments about the labour market (more on that later). The Fed Chairman Powell sees further hikes but investors focused on the potential for cuts through the second half of the year.

The Bank of England (BoE) was next up, delivering a 50bps increase, which took Bank Rate to 4%, not that the big banks seemed to have noticed in relation to savings rates. Perhaps a swift rap over the knuckles at this week’s Treasury Select Committee will help. With domestic inflationary pressure stronger than expected the decision to move was supported by seven members, although two voted for no change. However, forward signalling was dovish, with the BoE dropping its reference to "future increases in Bank Rate may be required" preferring to say that further tightening in monetary policy would be required if there was evidence of more persistent inflationary pressures. A subtle change in emphasis but enough to light the blue touchpaper. Both equities and bonds rallied strongly on this, sensing that Spring was approaching.

The hawkish European Central Bank was not to be left out, delivering a well flagged 50bps rate hike and following it up with a strong message: there will be another 50bps hike in March. This surely was going to stop the rally in bond markets? No way. The sense that disinflation was gaining ground, courtesy of lower energy costs and reduced supply bottlenecks, was not derailed by comments that underlying inflation factors were "strong, solid and are not budging".

So, by last Thursday there was a bull market in government bonds, credit and equities. I have not seen a well flagged UK rate increase of 50bps met by such a euphoric response as we witnessed in gilts. By the end of that day, five-year UK government bond yields were well below 3%.

Last Friday was a wake-up call, as non-farm payroll data echoed Fed Chairman Powell’s comments about the US labour market. Payrolls rose 517K (consensus: 189K) and the unemployment rate fell from 3.5% to 3.4%. There is likely to be some distortions in these figures but the message to me is that the labour market is tight and investors may be premature in looking for the famous Fed pivot to lower rates. US Treasuries took the data badly with 10-year rates moving back above 3.5%, after a low of 3.35%. European markets were a bit less impacted. Over the week German 10-year yields fell 5bps whilst the Italian equivalent settled around 4%, a drop of 7bps. The real winner though was the UK, with the 10-year rate ending the week just above 3%, 60bps lower since the start of the year.

The disinflation message was welcome but I feel that the celebration in the gilt market is premature. Domestic inflationary pressures still look strong and the BoE has actually become less pessimistic on the economy – good for growth but potentially bad for interest rates. I remain puzzled by the UK labour market, with it proving much more resilient than expected. Looking at what is priced into yield curves shows a Bank Rate rising to 4.25% in Q2 before falling to 4% by the end of the year. I think a cut will only be achieved if we see material weakness in employment.

Credit markets were not left out of the rally last week. Non-gilt sterling credit spreads moved lower, ending the week below 1.4%, a significant rally from the levels of the Liability Driven Investment panic in September last year. New issuance has been more balanced, with bank debt being a bit less prominent. There was a new deal from IBM, a rare issuer in sterling market; this was well received with the achieved spread being 20bps lower than the initial indications. High yield markets were also in good form – my preferred measure of credit spreads is 75bps lower since the start of the year. On the currency front the US dollar rallied on the labour market data, reversing the weakness seen recently. There seems to be a general consensus emerging that the US dollar will remain weak during the year, as rates are cut in H2. I am not so sure.

Let’s end on my meteorological analogy. I sense that Spring is around the corner. Unfortunately, I think there will be a cold snap before we get there.


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