The calm after the storm, will central bankers provide clarity?

There has been some stabilization in the markets overnight after Wednesday’s rout that saw the FTSE 100 drop nearly 1.5% the Eurostoxx index fall nearly 1%, and the Nasdaq fall 0.5%. Asian stock indices have reversed earlier losses, and the Hang Seng and the China Composite Index are both higher and Japan’s Nikkei is only experiencing mild losses. This sets the scene for a calmer start to the trading day on Thursday, after wild swings in markets, particularly in bonds, that we saw on Wednesday.

UK: bond vigilantes are never far away

The bond market had a severe reaction to both the higher-than-expected UK inflation figures, and also the plethora of central bankers who have pushed back on the market’s view that interest rates will start to fall from early spring. The 2-year UK Gilt yield rose by 21 basis points on Wednesday, to 4.37%, the highest level since December. This was a huge daily move and is a reminder that if the UK’s economic data, particularly inflation data, does not play ball, then the bond market vigilantes are never too far away

The market may have overreacted to one month of inflation data from the UK. As we have mentioned, we believe that the disinflation trend for the UK is still intact. Although the national minimum wage will rise in April, the energy price cap will fall. Producer price data was lower, which suggests less pressure on consumer prices down the line, wage growth cooled and there are signs that the labour market is cooling gently. Thus, the bigger driver of Wednesday’s move was  central bankers, most of whom were speaking at the World Economic Forum in Davos.

ECB ‘commits’ to summer rate cut

Central bankers at the Fed and ECB seemed to be unified in their message that the market had got ahead of itself when it came to the timing of rate cuts. This public and somewhat coordinated chastising of market interest rate expectations was enough to spook the market, however, we do not think that we will see the same level of volatility, particularly in the bond market, that we witnessed on Wednesday.

ECB officials, including President Lagarde, said on Wednesday that a summer rate cut was ‘likely’. While she cautioned that some inflation indicators remain too high, this message was a clear indication of intent, and almost a pre-commitment to cutting rates this year. Lagarde is usually more guarded than this, perhaps it was designed to stabilize markets after Wednesday’s surge in bond yields? Thus, the markets may be soothed as we move to the end of the week by the news that interest rate cuts are coming, albeit not as quickly as they had expected. Later on, Thursday, Fed voting member Raphael Bostic will speak on the economic outlook. He is considered a dovish member of the Federal Reserve and could balance out some of the more hawkish ‘higher for longer’ commentary that we have heard this week.

The re-calibration of interest rate expectations is a painful process, as we saw on Wednesday, but markets may take a pause on Thursday since we have had more clarity on where rates will go from the ECB.

Why UK yields moved higher than elsewhere.

UK bond yields moved higher across the curve, and experienced larger increases than Treasuries or German bond yields on Wednesday. This is the continuation of a trend that we have seen since May, with UK bond yields moving higher than their counterparts in Germany and the US on a normalized basis, as you can see in the chart below. Wednesday’s move higher in UK yields seems slightly unfair on the surface since the UK’s inflation rate is now back in line with its G7 peers, and its annual headline rate is lower than the rate in France. However, the Bank of England have tended to voice concerns about high levels of inflation in the UK, and there were fewer rate cuts priced in to the UK, which might be why the move in UK yields was higher on Wednesday, since the market assumes that the overall level of interest rates will continue to remain higher in the UK than elsewhere.

Chart: UK, German and US 2-year bond yields, normalized to show how they move together

Source: Bloomberg

The market reduced its bets that the Federal Reserve will cut rates in March. According to the CME’s Fedwatch tool, there is now less than a 60% chance of a March rate cut from the Fed, last week this was nearly at 80%. This comes after stronger than expected retail sales data from the US highlighted the strength of the consumer at the end of 2023. The Fed’s Beige book, released late on Wednesday, also pointed to solid consumer demand.

Oil price rises

Elsewhere, there were more strikes from the US on Houthis rebels in the Red Sea, which is pushing the oil price higher. The price of Brent crude is now back above $78 per barrel, and this could boost the energy sector in the FTSE 100 when it opens later. The oil price continues to trade in a fairly tight $5 range so far this year, which suggests that plentiful oil supply is countering the geopolitical tensions in the Red Sea.

UK housing market starts 2024 on a high note

There was more good news for the UK housing market, the RICS survey found that UK estate agents are more upbeat about sales than at any time before the pandemic. It also reported that its gauge of 12-month sale expectations had jumped by 10% to 34, the highest level since February 2020. This upbeat mood is probably down to the decline in mortgage rates in the UK, however, if we continue to see yields climb in the UK then these cheaper mortgage deals may not last for too long, and lenders will be forced to increase their mortgage rates as their costs to borrow also rise.

The FX view and a weaker Treasury auction

The FX space has been less volatile than other sectors of the market, and the dollar has fallen across the board. GBP/USD is testing $1.27 at the time of writing, and EUR/USD is back above $1.09. This comes after a weaker than expected $13bn US 20-year Treasury auction. The yield at the auction was 0.8% higher than the market’s expectation, and demand for the debt was lower than recent auctions. This was the weakest demand for a 20-year Treasury auction since July 2021. Due to the increase in Treasury supply in 2024, it is worth watching demand at Treasury auctions. On its own, this weaker auction should not impact market sentiment, however, if this is the start of a trend then it could trigger risk aversion and a sharp rise in Treasury yields.