Despite the imminent end of the Fed’s rate hike programme and the decline in growth and inflation expectations (five-year inflation swaps five years from now are below 4%, compared with almost 6% in the last quarter of 2022), nominal yields are on fire. This pushed the real yield on the US 10-year bond, which had hovered around 1% at the end of the first quarter of the year, to 2.4%, its highest level since the 2008 financial crisis.
The US deficit, fears of declining foreign demand (particularly from China, whose portfolio of US Treasury bonds is estimated to have fallen from $1,100 billion to $800 billion since the start of 2022 – compared with $1,300 billion at its peak in 2013) and expectations of a hawkish pivot by the Japanese central bank (rumours that it had intervened on exchange rates on Monday appear to have been denied, however) are putting pressure on the US bond market.
For the first time in the history of modern America, we are heading for a third consecutive year of losses on investments in Treasury bonds, which are not leaving the global pool of investment grade corporate debt (rated BBB- at least) unscathed. Aggregated by the Bloomberg global index, it has now posted a negative performance since the start of the year, following a fall of more than 5% since its July highs. It has not been helped by violent curve movements: interest-rate volatility is back to the frightening levels of 2022.
Surprisingly, equity volatility remains contained.
Apart from a few specific cases (Alstom’s cash flow warning, which fell by 37% on Wednesday, for example), equity index volatility is not affected as much by interest rate volatility as it was last year.
This may be due to a change in the way hedges are set up in the trading rooms of the major banks. They seem to be hedging their client exposures with daily maturity options, in order to limit their overnight risk. The result is that the short gamma (the speed at which an option becomes increasingly sensitive) is less acute than in the past, and is insufficient to accelerate downturns… to the detriment of perfect hedging of the entire volatility layer by banking counterparties. It is hard to predict the consequences of a black swan. But without such an exogenous and unpredictable shock, investor sentiment, however negative, cannot cause indices to plunge by more than two percentage points per negative session.
Nevertheless, the decline in equity indices has been slow but steady since the start of the month, and there is a growing decorrelation between falling share prices and the outlook for earnings growth in Europe, still buoyed by perhaps over-optimistic expectations.
The optimism of analysts, focused on specific factors, no longer seems to be convincing investors, who are once again obsessed with top-down risks. These include, first and foremost, the unexpected and violent tightening of financial conditions, orchestrated de facto by the market and which, for the time being, the FED does not seem totally prepared to oppose. Does the market, this Deus Ex Machina of financial conditions, risk breaking the economic machine beyond what Jerome Powell, like a dethroned demiurge, cannot accept? If so, could it threaten the soft landing and increase the risk of recession in Europe? Could it have a faster-than-expected impact on business performance and order books, which have so far held up better than expected?
It’s possible: high interest rates are putting pressure on working capital financing. They are encouraging manufacturers, and also purchasing managers on the customer side, to draw on their inventories without replenishing them, which does not augur well for a rebound in business. Isn’t this what we’re seeing today in the copper market, for example, where visible inventories, while still historically low, are being replenished as traders, producers and industrial participants release stocks on the markets to reduce their increasingly onerous financial leverage and rebuild liquidity?
The reaction of central banks is difficult to anticipate, which adds to the anxiety. Jerome Powell’s pious hope of monetary orthodoxy could be met by the protests of the candidates in the 2024 presidential election. They will not fail to mention the cost to savers (mortgage rates at their highest since 2000) or to the State (debt servicing – USD 652 billion – rose by 25% in the first 9 months of 2023). This demagogic vision risks obscuring the reality of the road still to be travelled to normalise the liabilities of monetary expansionism. Despite the natural liquidation of the portfolio ($1 trillion), the Fed’s balance sheet still represents almost a third of US GDP, compared with 51.6% in the eurozone! Inflation has started to come down, but cyclical risk factors could swarm in at any moment, such as a slippage in commodity prices (most recently oil) or a seizure in the global supply chain (the difficulties experienced by the Panama Canal – 6% of world trade passes through it – which has been severely disrupted since this summer by the drought triggered by El Nino are reminiscent of the Evergrande episode).
Rather than asking whether the worst is over, the market is changing tack and asking how far rates can rise. This anxiety-provoking, self-fulfilling line of reasoning does nothing to help us determine whether we have reached the peak of our fears. The past may offer limited help, as the debt and deficit meters in developed countries are pointing towards terra incognitae of public indebtedness. While the El Nino disturbances in the Pacific are expected to last until February 2024, the financial turbulence is likely to last a little longer…
Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in October 6th, 2023.
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