Church House CEO Jeremy Wharton gives his usual in-depth summary of credit markets across the globe.
Geopolitical event risk has risen but appears to be relatively contained from a market perspective. The real story for financial markets leading into the fourth quarter was the continuing falls in Gilts at the longer-dated end of the market, taking their interest yields up to the levels for shorter periods (flattening the yield curve, a ‘bear steepening’!). Major western Central Banks are pausing their increases in base interest rates left, right and centre amidst hopes that we have found terminal rates, although recent data hasn't necessarily gone their way. Unfortunately, we look set for ‘higher for longer’, but this is better than ‘higher and higher’.
China’s situation forced them to the front of macro considerations as their post-COVID restrictions rebound has not materialised, and there is speculation about the potential for exported deflation. Their overheated property sector, 25% of the Chinese economy, is starting to look increasingly precarious and Evergrande (the biggest Chinese property developer who defaulted on $300bn of debt), filing for bankruptcy in the US coincided with Country Garden (the second biggest Chinese property developer) suspending payments on thirteen bonds, putting their $150bn debt pile in jeopardy too. The Chinese Central Bank’s response has been to tinker with rates in a meaningless way, which will not resolve the situation. We remain thankful that these debt obligations are largely held internally.
The reality of funding the US budget deficit is hitting home. The $6tn needed from the sale of Treasury Bills is a huge number. However, simply funding through T-bills is not possible, so the longer end of the Treasury market (the US equivalent of UK Gilts) has had to bear the brunt of a trillion dollars of new bond issuance. Whilst this has been taken reasonably well overall, the last auction of thirty-year Treasury bonds was weak, and the net effect has been to push thirty-year interest yields higher by half a percent, which equates to a fall in capital value of almost 9% for bondholders.
US housing market activity has fallen off a cliff as thirty-year fixed mortgage rates have risen to 7.9%. A major part of the supply of housing is stifled by existing mortgage holders having no wish to move and refinance at these higher levels. Before the recent Federal Reserve meeting, US five and ten-year Treasury yields hit their highest levels since 2007, pre the Global Financial Crisis, influenced by rising oil prices and a worrying Canadian inflation print. The Federal Reserve kept their funds target rate unchanged but still with a tightening bias just to keep everyone on their toes. We still appear to be on course for a further hike before the end of the year, but presumably this remains ‘data dependent’. The Fed sounded noticeably more optimistic on economic activity for 2024, their forecasts only predicting the potential for just one 0.5% cut in their rates next year and then to remain on hold until 2025/2026. These forecasts are liable to move as we know, but either way the US economy looks resilient and might well achieve a ‘soft-landing’.
The picture in the Eurozone is much more fuzzy. The ECB did deliver a ‘dovish hike’ of 0.25% to a 22-year high of 3.75% (against economists’ consensus for a pause}, to then hold at their next meeting. The ECB have probably found their terminal rate and weakening growth in major EU economies will be top of their minds, as too will be stubbornly high near-term inflation data (although underlying inflation pressures are easing, and forecasts show a more rapid fall}. They did not change their stance on selling-down their bond holdings, being content to stop reinvesting maturing bonds under its Asset Purchase Facility, but still reinvesting maturing principal payments under the PEPP (the pandemic one}. It’s all the same balance sheet in my view. The Eurozone economy remains asymmetrically reversed as the olive oil economies still have solid growth, while Germany flounders. Greece regained investment grade status; they’ve come a long way since 2011.
The Bank of England held rates with better prints for CPI at 6.7% and GDP at 0.2%. To cover our budget deficit we need to raise £238bn through new Gilt issuance over the year, a fair proportion from our long end too. One year on from last year’s Truss/Kwarteng muppet show and the long end of the Gilt market is seeing greatly reduced volumes (an ‘illiquid ghost town’ is the word}, exacerbated by greatly reduced Liability Driven Investment activity.
The UK economy does not present a particularly pretty picture as we printed weaker July GDP numbers than expected, mainly due to a surprise drop in the contribution from services. The drop in industrial and construction activity was expected. Subsequent GDP numbers were a shade better. Unemployment increased slightly and it looks as though private sector wage growth has found a level, but overall average earnings growing at 8.5% remains punchy. A surprise and welcome drop in August inflation numbers, in particular a healthy drop in the core rate to 6.2%, almost putting us in range of other major economies, must have been a major contributor to the MPC’s surprise 5/4 split vote to hold rates at 5.25%. The picture was also clouded for a while by a rally in energy prices (largely prompted by industrial action in Australia and US oil inventory data}, which fell back for a while, but are now rising again due to fears of a major escalation of Middle East tensions following the unfolding Israeli/Palestinian situation.
The Sterling primary market has been unusually busy as a few foreign issuers took advantage of favourable cross-currency swap rates to issue in sterling and some high coupons have printed. We even saw some non-financial issuance from quality A-rated issuers such as Caterpillar and John Deere, which were well received with healthy order books and strong performance in the secondary market. Issuance across all currencies remains healthy but Friday has almost become a ‘non-primary’ day as we saw the 33rd zero-issuance Friday this year.
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