Jonathan Gregory
Head of UK Fixed Income

Living and working in London demands various survival strategies to manage inevitable challenges that beset city dwellers. For the British, one of the most essential is simply getting from A to B on public transport while retaining a sense of dignity, poise and modicum of personal space. And problems aren’t confined to rush hour alone; leaving a modern 60,000 seater football stadium en-masse at the final whistle, then descending into Victorian era transport infrastructure is not for the enchlophobic or time-pressed.

Until recently though, this particular problem was fairly easily managed. Premier League football games rarely ran much over the 90-minutes, perhaps 2-3 minutes of added time being the norm. So a smart survival strategy (at least for fans of a dilettante persuasion) was to leave just before the full-time mark, while the game had only minutes to run and ‘beat the rush’. Nothing much happened in the last few minutes anyway; you could leave before the end and not miss anything, knowing the win was already assured. (Well, certainly in the case of my team, usually 1-0 up by then; as that scoreline is something of a speciality, with even a song about it).

But football authorities felt the need to intervene and handed free rein to referees to add more time at the end of a game to make up for perceived time-wasting by players trying to see out a narrow win. Suddenly, added time of 10 minutes or more is not uncommon and the extra minutes have almost become a game in-itself, demanding their own tactics with plenty of late drama and unlikely comebacks as players tire.

Before fans became acclimatized to the new regime, those who left a game 1-0 up around the 90 minute mark enjoyed a happy and stress-free tube ride home but then suffered the emotional agony an hour later, finding their team in fact lost 3-1 and they missed 10% of the game they paid to see (well, if you missed your team losing 3-1 after leading 1-0 on 90 minutes I imagine that would actually be a blessing, but I don’t think football rule-makers ever had benevolence in mind).

Ah, the crushed premature celebration of the football fan. Does anything suck the joy out of life quite like it? Well, bond markets have their own reality check now that monetary authorities have got in on the act of adding lengthy extra time to a result you thought was already decided. The euphoric sense of victory in the fight against inflation that gripped bond markets in late 2023, and drove strong returns in the final weeks, has ebbed away in the early weeks of 2024. Global bond yields (as represented by the Bloomberg Global Aggregate index) are about 30 basis points higher today than at the end of December. A key driver was central banks themselves pushing back on the idea that interest rate cuts are coming as soon as investors had hoped a few weeks ago, and adding ‘extra time’ to the period that policy rates will be maintained at current levels.

We had said in January that market pricing was getting ahead of itself with the degree of rate cuts priced for the US and Eurozone by summer 2024. Recent bond market weakness reflects a healthy roll-back of those expectations. At the time of writing, market expectations now imply the Federal Reserve (Fed) and European Central Bank (ECB) will each cut rates twice by the end of July (assuming 0.25% for each move), compared with nearly four cuts priced in the same time period a few weeks ago. Today’s pricing seem much more reasonable to us.

But the anomaly in pricing now seems to be that the market expects the same policy moves, and in the same time frame, from both the Fed and the ECB. While this might reflect an eerily similar central bank narrative about the extra time required to be sure inflation is really heading back to target, the data paints a contrasting picture across regions.

At face value, the Fed seems to have the strongest case to call for added time; the US economy is still strong as evidenced by recently released Fourth quarter GDP of 3.3% on an annualized rate, and even more recent data showed that the economy added about double the expected level of jobs in January. Fed Chair Jay Powell has acknowledged that it was “historically unusual” that rate hikes delivered so far had not triggered a sharper slowdown in growth and jobs.1

Contrast this with the Eurozone; Fourth quarter GDP was zero (and negative in Q3), with consensus expectations of about 0.5% in 2024 and well below trend. Forward looking indicators for the health of the economy – such as Purchasing Manager’s Indices (PMIs) – are also tracking well behind the US.2 But ECB Governing Council members were out in force in Davos recently, downplaying the chance this would mean easier policy in coming months.3 Arguably the only thing the two blocs have in common at the moment is a strong labour market. Eurozone unemployment hitting a record low of 6.4% in November (but note, still double US levels).

So, if you tuned-out central bank talking-heads and just looked purely at the data you would probably conclude rate cuts are likely in both markets, but more probable, and sooner, in the Eurozone. After all, both the Fed and the ECB have remarkable similar expectations for the trajectory of inflation back towards their targets this year/early next.4 So surely market pricing that implies similar policy paths must be wrong?

I think this is a reasonable conclusion to draw on data alone but some recent ECB commentary lays out the counter arguments. Isobel Schnabel is a member of ECB Executive Board, former professor of financial economics and past member of the German government’s Council of Economic Experts. I am none of those things and you will therefore handicap our views accordingly.

Her comments in a recent FT interview were worthy of note for anyone feeling bullish on Eurozone yields here.5 In it she downplayed the potential future impact of the rate hikes seen so far; she downplayed the case that a supply-shock was mostly to blame for higher inflation in Europe; she highlighted that bank lending rates were falling (and so might support consumer demand); she focussed on high wage growth and weak productivity and spent significant time on the possibility that structural factors, such as the green transition and higher defence costs, might mean higher relative real policy rates in future (a case we have made before).

Apart from the risks around higher structural inflation in the long run, I do not agree with all her arguments. I doubt that all staff ECB staff members do either – particularly because most households suffered a severe negative real income shock during the energy crisis and higher wage demands today simply reflect a desire to restore spending power to pervious levels, rather than risking a wage/price spiral. This seems quite different to the US where a large fiscal boost to growth had a major positive impact for households that still shows up in demand today.

But the comments do probably highlight that, given the political realities across the bloc, achieving some sort of consensus around the appropriate policy rate is harder (and takes longer) at the ECB than almost any other central bank.

So, in that sense we might conclude market pricing across the US and Eurozone is in fact correct – the US reflecting still strong economic fundamentals with the Fed wanting to wait as long as possible for the first rate cut and the Eurozone pricing simply reflecting the ‘realpolitik’ of policy making there.

It might be even simpler. If there is one lesson to take away from the last couple of years it is that the post-COVID, energy-shock world has been a tough one to call; previous policy-making modes of thought and models have not been reliable guides in the new world. In particular, those models that link employment to inflation or financial conditions to final demand seem to be mis-firing of late.

Perhaps the central bank call for added time now is simply a reflection of their desire to recalibrate their policy frameworks, or at least feel greater confidence the prior versions are working again. Isobel Schnabel’s comments lean in this direction. Certainly, forward-looking estimates of inflation seem to be playing less of a role in rate setting today than they would have done in the past.

All of that said, market pricing and investor sentiment seem more reasonably balanced now than in early January, which is a good thing. If bond yields continue to move higher from here we expect to add duration in our Global strategies (add government bond market exposure) and the weakness of the Eurozone economy is starting to make that market look attractive. If the US economy remains strong but lower inflation does allow the Fed to ease then ‘curve-steepeners’ (owning relative fewer long dated bonds) will make sense.

The final whistle on the inflation story has not sounded, in fact it might be about to enter into its most interesting phase. Don’t leave your seat just yet…

S-02/24 NAMT-660

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