The data tail continues to wag the central bank dog, as it has for some time, and wrong-foot forecasters. Some strong US data prints pointing to a seemingly rock-solid US economy provide food for thought. A startlingly strong ‘non-farm payrolls’ number (essentially their employment statistics) played havoc with interest rate futures markets as they moved to discount a later than expected cut in their base rate. An upcoming inflation figure could do the same again. Jamie Dimon, the long running and well-respected head of JPMorgan Chase, the world’s biggest bank, unsettled a few people by saying that the bank was ready for a “very broad range” of rates from 2% to 8% or even higher. I’m not sure that adds much, although his bank and others have done well out of this rate cycle.

The US Treasury bond yield curve moved in sympathy and the ten-year rate reached year-to-date highs, moving from around 3.8% to approaching 4.5%. Members of the Fed’s interest rate setting committee (FOMC) reiterated that they are in no hurry to cut rates although the message has become a little more fragmented lately. Chairman Powell’s indication of three cuts by year-end (also asserted by ex-Fed’s Bullard) is countered by Atlanta Fed President Bostic, a voting member of the FOMC, saying he now thinks the Fed should stick to making just one cut this year.

With relatively little fanfare, it appears that the Bank of Japan has started the beginning of a meaningful rate-hiking cycle (having not raised rates for seventeen years) by ending their negative interest rate policy along with ‘Yield Curve Control’ (and buying stock market Exchange Traded Funds…), largely prompted by solid wage inflation. Thirty-five years after the pricking of their asset price bubble in 1989 their equity markets have finally regained those levels. Japanese debt to GDP ratio is 260%, more than US $9 trillion or 1.25 quadrillion yen (?!) and the Bank of Japan owns close to 50% of this debt, while retaining the option to buy more. Possibly, this shows the downside of pursuing a negative interest rate policy for so long. Small wonder that the Bank for International Settlements continues to caution developed economies about their amassing of debt.

Eurozone inflation has come in below expectations, giving the ECB something to consider and German inflation has reached a three-year low as their industrial base has stagnated and manufacturing output contracted. With subdued levels of activity in the single currency bloc’s main economies, the case for the ECB being the first to cut rates is growing and some of their central bankers are openly advocating this. In contrast, the peripheral economies, previously known as the PIIGS, have staged a remarkable recovery and are currently the collective engine of the Eurozone. Greece in particular has come a long way from being bailed-out in 2010, then 2011, 2012, etc., and has now even been raised to sovereign investment grade status.

The UK’s recession appears to have been as shallow as hoped and activity has regained some momentum in the first quarter.  Retail sales have been volatile as ever but overall are encouraging, as is consumer confidence, and if inflation continues to fall back and labour markets remain firm, the Bank’s task should be straightforward despite a looming election. A damp squib of a budget did nothing for the electoral chance of the Conservatives.  Thanks to our fragile level of activity, the UK is also potentially ahead of the Fed in cutting rates though the inflationary consequences from any resulting weakening in sterling would be unwelcome. The moves in our ten-year Gilt yield have been less pronounced than in the US, centred roughly around 4% but still a long way from the 3.5% where they started the year {entailing a near 5% loss in capital value).

Appetite for credit risk remains unabated however and this is evidenced in the stability of credit spreads, the yield premium received for investing in corporate and financial bonds over sovereign debt. Sterling investment grade spreads have tightened in from 1.4% to 1.2% over this first quarter and there continues to be strong demand from investors in both the primary and secondary markets.

The Thames Water story remains localised to them with limited spill-over into other companies in the sector, but it remains as a £16bn problem for holders of their debt. Kemble, the holding company, has already defaulted on its debts at a cost of £1.6bn but relying on the ring-fencing  of  their  operating company {Thames) debt will not necessarily avoid losses or ‘haircuts’. We did own the Thames 4% 2025 bonds but sold these in January to buy their new longer-dated 7.75% 2044 bond, but we can report that these were sold before it all began to unwind. Their whole capital stack{their stock of debt in issue) now looks to be in a sorry state.

The first quarter’s primary issuance by both corporates and banks was at a record high level since the Global Financial Crisis.  All-in yields remain compelling and credit markets have comfortably outperformed the Sovereign bond markets.  Moving further up in terms of quality still feels like a sensible tactic as default rates tick up in echelons of high yield and individual credit problems {like Thames Water) come to the fore.

The full Quarterly Review is available here. 

April 2024

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