The bond markets seem relieved that inflation is finally coming down in the US?
The recent consumer price Index (CPI) wasn't really that big of a surprise in a broader context. Core Inflation was only about five basis points lower than our forecast in October. The components that contributed to the surprise versus our forecast were travel services type of components, which are volatile. Another important point is that the market has been focusing on owners’ equivalent rent and rents in the United States, which make up a large portion of the CPI. These rent components have also been volatile recently, but smoothing through the noise, rental inflation is down clearly on a downward trajectory. Overall, the October print didn’t change the broader story, which is good prices are normalizing after pandemic-related distortions, shelter inflation is moderating, and inflation in categories that are more directly impacted by wage inputs costs is still sticky.
Beyond the monthly volatility, will inflation now normalize?
Both headline and core inflation have been moderating meaningfully from their peaks. This has happened as both demand and supply have normalized. The impact of both fiscal stimulus and product shortages is fading. However, the question still remains, once these pandemic related price distortions fade, what is the underlying trend in inflation absent and increase in the unemployment rate. Since the super core measures that the Federal Reserve Bank Fed is focusing on are moving sideways at a still elevated pace, that underlying trend might be higher than what the Fed is comfortable with.
What is your forecast for next year?
The CPI we estimate to run somewhere between 2.5 and 3 percent. Core inflation (PCE) will be about the same level. We think that inflation outlook, coupled with our expectation for more labor market cooling, is consistent with a forecast for the Fed to start cutting rates in second half of 2024.
What does this mean for the bond market and rates next year?
The increase in yields that we saw in late summer and early fall wasn't driven by changing expectations for the near-term path of the Fed monetary policy. The interest rate curve bear steepened. Usually when you see that kind of move, especially in real rates, its symptomatic of term premiums increasing, and the market being more worried about the supply picture of Treasuries.
Are these higher yields equivalent to more monetary tightening?
An increase in 10-year Treasury yields off around 100bps this is equivalent to around 75 basis points in Fed fund rates tightening.
Is the supply side a big issue in the market?
We think the outlook for greater government bond supply is effectively priced in. We do not expect to see explosive growth in US budget deficits. The US doesn't have a fiscal sustainability issue right now. The long-term outlook for US deficits is concerning because of expected entitlement program sending, due to the aging population. At some point, it must be corrected, but that doesn’t mean that the debt isn't sustainable today.
So given no supply issues short term, are bonds attractive now?
With the recent push towards 5 percent yields in 10 year Treasury Bonds, bond yields have started to look attractive. Bonds look attractive relatively to their own history and other asset classes. You currently aren’t getting a lot of additional spread and earnings yield by investing in lower quality credit and equities.
Have we seen the peak in US interest rates?
The central banks have started to feel more comfortable because they are more convinced that inflation is moving in the right direction. The Fed clearly signaled a pause in interest rate hikes, similar to other developed market central banks, and articulate what it needed to see to resume hikes: continued above trend growth; inflation reaccelerating; labor markets imbalances that aren’t easing. Otherwise, they made pretty clear that they have policy at the level that want.
A Swiss Investment Bank expects the Fed to cut rates in 2024 by 275 basis points. Do you agree?
The Fed told the financial markets that they will start to cut interest rates and normalize policy once they feel confident that inflation will sustainably meet their target. In order to feel confident, they need to see the US labor market in better balance, including a rise in the unemployment rate. That is what we are getting now. The unemployment rate has started to rise slowly and we have seen improvements in labor market imbalances. The worry is that the unemployment rate will start to rise more quickly, and indicate that they US is in recession. If this were to be the case then there is no doubt that the Fed will cut quickly.
In what magnitude does the Fed cut rates in the case of a recession?
In a recession the Fed cuts by 300 to 500 basis points on average and they have the room to do that. On the other hand, if we have only a mild downturn, growth stagnation scenario then the cutting cycle come be slower.
How large is the recession risk?
We project that the US will have stagnant growth next year and there is a high probability of a recession. Historically, when monetary policy is tight, and the central bank has aggressive hiked rates to moderate inflation, economies almost always realize some kind of recession.
The high yield bond and equity markets are resilient and don't indicate a recession so far.
Credit spreads in general and equity risk premium suggest that the additional earnings yield over treasuries is not pricing enough probability of a recession. Because equity risk premiums are just in the middle of the historical range, or, if you look at equity earnings yield versus BBB-credit, investors can get more yield by buying a BBB bond than investing the equity market. As a result, we don’t think there is not a lot of value in overweighting riskier assets in this kind of uncertain environment. You can construct a relative safe portfolio, with bonds, that has a decent yield.
Will people move money out of the equity into the bond markets?
Well, this is what Central Bankers are hoping. Central banks are trying to tighten all financial conditions to slow their economies. Tighter financial conditions, is not only higher bond yields but also wider credit spreads and lower equity prices. Tight financial conditions will have an impact on the economy over time as new credit becomes more expensive, and more companies roll over their debt at these new higher interest rate levels. We estimate that about 500 billion of debt has to be rolled over next year, at interest rates that will be 350 basis points higher than what they are paying now. Small and mid-cap companies, who have higher levels of variable rate debt are already feel the pinch from higher rates.
The earnings growth is still healthy; however sales growth starts to slow down?
The consumer is becoming more price sensitive as excess saving accumulated from government support during the pandemic has been depleted. At the same time, interest and labor expenses have increasing. This is a recipe for falling margins, and weaker profits, which will impact equity valuations.
