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STATE OF AFFAIRS
Many students are facing a series of exams over the month of June. If you were to submit to students in economics questions on the behaviour of bond markets the moment US headline inflation hits 5.00% and 3.8% for core inflation, I reckon few would respond with confidence that US Treasuries would rally aggressively, shaving about 10bp from 10-year rates. Yet, that was the outcome: 10-year US rates dropped from 1.55% towards 1.45% over the week. What’s going on here? Again, several market strategists point to a technical short-covering counterrally. Others mention the continued rebalancing of pension funds towards US Treasuries, as most of them achieved funding levels close to 100%. “Better safe than sorry”, many pension boards must shout, and demand for long-end US Treasuries and long US strips remains high and persistent. However, the former is inherently short-term, and the latter loses intensity. Fact is that a growing number of participants tentatively start to agree with the temporary nature of the US inflation surge. Interestingly, the US experiences, again, an exceptional condition. Indeed, inflation numbers in Europe have hit 2.00%, a far-cry from US levels. Sweden posted a 1.8% print for YoY inflation in May. China impressed on PPI with a print of 9.00%, but inflation disappointed somewhat at 1.3%. At the end of May, global inflation sat at 2.7%. Such a number was present over 2018-2019. Consensus sees global inflation falling back towards 2.2% to 2.4% by year-end. But, if the ‘too high for comfort’ inflation condition is temporary, we should pay attention to other indicators. Today’s message centers around the elephant in the room called labour market recovery. Today’s inflation debate might be the wrong debate in relation to the shape and the level of US rates. The debate should shift more towards the shape of the US labour market recovery and impact on US rates.
The US labour market recovery after the Great Financial Crisis of 2007-2009 was highly protracted and the unemployment rate only went below 5% during 2016. Over March-April 2020, more than twice as many jobs were lost. Over the summer of 2020, about a third of the job losses was recalled. The US boasts a high economic growth recovery pace and unemployment has dropped to 5.8%. Suddenly, the last two non-farm payroll (NFP) numbers disappointed and the US is still about 7 million jobs away from the levels witnessed at the end of 2019. From past recessions, we observe that three issues require attention when employers are faced with high unemployment conditions. First, companies have more trouble choosing which new employees to hire. Second, employee rotation in sectors less hurt or even profiting from the pandemic is rising, creating longer lead-times in seeking apt replacement. Third, bank lending recovers slowly the moment certain sectors want to expand their operations as uncertainty remains high. The first two issues relate to skill mismatches that, at present, occur across winning and losing sectors. Moreover, the most impacted sectors (leisure and hospitality, retail trade, entertainment and recreation) might see a larger share of permanent job losses. The labour market structure made a transit towards more service-related jobs than goods-related jobs. Scarring is deep in low paid servicing jobs. Temporary layoffs will become permanent. Hordes of people that currently enjoy high unemployment benefits might have a nasty awakening once they try to re-enter the workforce. The point I make is that in order to close the labour force gap in a qualitative fashion, with proper pay, we might have to pencil in a longer timeframe.
We require about a gain of 300k a month on non-farm payrolls (NFP) over the next two years, to reach Q4 2019 employment numbers over the summer of 2025. Under a scenario where, on the one hand, small and medium enterprises in their struggle for survival decide not to hire or hire less, and, on the other hand, the superstar firms, aiming for higher productivity levels, hiring more slowly as well, the above two year timeframe might get stretched. Platform-based, network dependent business models are adopting telework as part of the contract package, thus saving on labour costs and total required FTE’s. Under a +200k average monthly NFP gain we make good on 7 million jobs by the summer of 2026.
The US Treasury market is aware of this. Such an outcome, closing the labour gap by 2026, would leave the US Fed less room to tighten monetary policy. Reaching labour market normalisation will control the path towards policy normalisation. The Fed has prioritised maximum employment in the treatment of its threefold mandate. Steady growth is achieved by collaborating well with the Treasury department, rolling out a yet-to-be-determined fiscal policy. Inflation becomes residual. The unofficial fourth objective of financial market stability might be reached under the known gradualist approach, including a light-switch conduct in the use of the QE weapon. The previous interest-rate cycle took three years (Dec 2015-Dec 2018) and lifted policy rates towards 2.5%. The future might confront us with a sequence of lower lows. The interest rate hiking cycle ahead of us might ‘only’ stretch to 1.5% or 2.00% as we mentioned in past weeks. That might explain why US 10-year rates broke the 2-month-old 1.50%-1.75% range. The moment the market switches the inflation narrative in exchange for the labour market recovery narrative, we might step into a 1.25% – 1.50% range for US 10-year rates.
The bull flattening continued unabated for a second week in a row. May labour market numbers cemented the bottom, and participants sensed that the 1.75% print on US 10-year rates was the high. The inflation numbers could not reverse the plot. The US yield curve added another bull flattening episode. Bond markets focus on the correct indicators and neglect CNBC and inflation fear-mongers. Fair enough, it was a surprise to see inflation expectations drop off rather aggressively. 10-year breakeven rates collapsed 8bp from 2.42%, closing at 2.34%. Expect consolidation to set in. This week all eyes will be on the Fed’s FOMC outcome and Fed Chair Powell’s press conference. Let’s do a word count game. How many times will he mention the inflation versus the labour word? I bet labour wins.
Impressive. European Government Bonds (EGB’s) took back 54bp over the past week. The year-to-date performance tally stands at -2.80%. The ECB meeting delivered no surprises. They settled for inflation at 1.4% over 2023. They do not reach their objective. In fact, the market estimates that they will not achieve their inflation objective over this decade and beyond! So, expect the pegged rate system to remain in place for longer.
We had a strong echo and again, on the back of strong EGB’s, European Investment Grade (IG) credit and High Yield (HY) credit surged ahead with 34bp and 37bp respectively. The IG corporate bond sector is losing on the zero line. The HY passed the 3% handle, closing at +3.14% for the year. With the issuance calendar closing into the summer months, it will take a big and bad surprise for those markets to get destabilised.
Since the start of June, emerging markets pencilled in around 1.50% of total return in EUR. Yields followed the downward path of US yields. However, the bulk of the performance came from EMFX appreciation.
The Russian Ruble is amongst the best performing currencies (+3.30% MTD in EUR terms), supported by another 50bp increase in the benchmark rate, now at 5.50%. Brazilian Real is visiting the 5.00 handle versus the dollar (+2.80% MTD in EUR terms) in anticipation of further hikes of the SELIC rate now that inflation is at 8.06% YoY.
Since the second part of last year, we have been repeating our view that gradual normalisation of emerging markets’ central bank policies will lead to stronger currencies since the second half of last year. High commodity prices and decreasing EMFX volatility (now at 8.50) support this view.
With around 60.000 votes or 0.35% difference, Pedro Castillo won the Peruvian elections last weekend. Given the narrow victory, Keiko Fujimori asked for recounts, but it’s rather unlikely they will change the outcome. A divided congress, in which Peru Libre holds only 37 of the 130 seats and which is dominated by smaller right-wing formations, should offer some comfort as it will be almost impossible to push through a radical nationalisation agenda. Pedro Francke, appointed economic advisor to the President has reaffirmed commitment to a responsible monetary and fiscal management. If the current, strong macro-economic framework and past political discipline is indeed maintained, bonds and currency are valued at attractive levels. Moreover, Peruvian fundamentals have been resilient through many turbulent political cycles in the past. Also ‘moral incapacity’ has been used many times to oust a President in Peru (we had three Presidents in a week last year) and can be achieved by two-thirds of lawmakers in the unicameral congress.
In the Mexican Chamber of Deputies, Morena and allies (PT, PES, PVEM) secured fewer seats at the mid-term elections, losing the two-third majority. The market reaction was positive, with especially the long end of the local curve in demand. With elections behind us and affirmation of Mexico’s rating by Fitch at BBB-, we believe Mexican local bonds are extremely attractive at spreads over US treasuries just above 500bp in 10-year maturities. A gradually-more hawkish Banxico will support the currency.
With exception of the Czech Republic (2.90% YoY), May inflation prints in CE4 continued to climb. Hungary (5.10% YoY) will most certainly hike rates at the next MNB meeting. Poland (4.80% YoY) will resist as long as possible and Romania (3.75% YoY) can afford to wait a bit longer. The slightly lower print in the Czech Republic will not delay the announced rate hike(s), but the appreciation of the Krona from 26.25 to 25.32 since the beginning of the year helped to bring inflation back within the 1% – 3% target band of the Central Bank.
We advise investors to upgrade the status of labour market recovery versus the mediatised inflation narrative.
The labour market recovery will prove to be protracted, as was the case after 2007-2009. However, inequality tensions might become more disturbing. The skill mismatch debate alongside the societal impact deserves more attention.
The US central bank treats inflation as a residual and labour market health as its true primary objective. The Fed has all the tools in place to control rates. The implicit yield curve control was often discussed in last year’s letters but has never left the stage.