One week, one sentiment. The other week, the other sentiment. One week, the sun is shining. The other week, the sky is grey. One week, we’re all bond bears. The other week, we couldn’t be more bullish. Welcome to a regular month of financial markets. One day, I’m bored. The other day, the Week at the Close is full of content to write about. Welcome to another article from Tra i Leoni’s column on regular stories of pure madness.
Some call this adaptation. Others, change of narrative. Some, more averse, call it the mood swings of the powerful. For the more tragic, it’s just the usual random roulette of opinions of market participants that is spun pretty frequently, and that determines consensus. Whatever you call it, we are here again. Just two weeks ago, strong economic reports coming from the US were making the case for higher-for-longer rates to come. The prospects of still-too-high inflation coupled with this further demand push coming from consumer and business strength made people think that the fight of the decade is far from over. Right now, however, the tables have turned upside down.
By the end of last month, the world’s biggest economy was reported to have achieved a quarterly just-short-of-5% annualized expansion in output: the greatest in 2 years, and significantly above estimates. This US growth came at the heel of a 4% increase in consumer spending, the main contributor to economic growth. To add to it, a new and big elephant has entered the room.
Fiscal deficits, or the trademark of the so-called “Bidenomics” bringing a boost to the economy, have surged during the year to a stunning $1.6 trillion. The Congressional Budget Office projects these values to bring the frequently quoted deficit-to-GDP ratio to around 6%: a level of fiscal burden not seen too often. The relevance of the rise in government expenses is big, given that they are mainly focused on infrastructure, the green transition, and the expansion of the crisis-hit semiconductor sector. The context is not surprising as well, given the soon-to-be presidential elections. The timing, however, may be achieving the difficult task of making Jerome Powell’s hair grow a little greyer.
All this obviously led to an increase in market rates, making them reach pre-crisis highs. 10-year yields topped 5%, and people were even starting to discuss a possible 6% future level. But the reaction was still a bit muted by an extra factor: the Treasury Department refunding announcement.
Last week, the US Treasury brought up something that many market participants were very closely following. The refunding announcement put forward by Janet Yellen set up a market reaction as the Treasury is now set to increase the sale of long-term debt securities by less than what most were predicting, concentrating instead on the issuance of short-term debt. Why is this important? Well, if for nothing else, this concentrates the new reduced supply of treasuries in the short end of the term structure. From Economics 101, a lack of supply in bonds brings in an excess demand scenario, pushing up prices for these securities. From Finance 101, prices up mean yields down. More importantly, the supply of bonds is even more restricted in the 10 and 30-year maturity spectrum of rates, and these are more impactful on the functioning of the economy.
This was the catalyst for what was to come. Suddenly, the economic strength came under the dominance of a bond-bullishness market feeling. J Powell contributed to it as well.
On the 1st of November, the board of governors of the Federal Reserve met for their usual gathering to decide on the policy rate of interest. As expected, the committee left rates unchanged for the second straight meeting. What is most important to note is the idea market participants seemed to get from the press conference speech: most likely, the tightening cycle is done for good.
These two factors combined with some economic prints that showed some unexpected weakness made room for the surge of the new narrative. The Fed is done, demand will overwhelm supply. Suddenly, let’s all buy bonds. It’s time to lock in yields.
Travelling to this side of the Atlantic, the ECB can take some relief from this new paradigm. The bloc’s economy, which is in clearly worse shape than that of the US, is facing some undesirable contagion of economic pain brought about by the high-rate environment in the US. Naturally, the effort made to bring us to restrictive territory by Lagarde and her governing council is exacerbated by what goes on in the US in terms of policy tightening.
However, this extra push in rates was disproportionate to the state of the economy in Europe. And it’s disproportional for two reasons: not only did eurozone inflation reach a 2-year low (at 2.9%) as shown by the end-of-October print, but also the economy faced a quarterly small contraction of output of 0.1%. At least for now, there is no apparent need for having monetary policy increasingly restrict the bloc’s situation.
But now, as I wrote before, the tables turned. US treasuries picked up, and US stocks rallied as a consequence. But hold on. This may last for a while, as this new paradigm gets into people’s minds. However, it’s a fine line we’re balancing on. Some weakness has been showing up in terms of recent data, so how fast will this recent movement go from end-of-tightening to begin-of-easing? How much of the story is really about economic pain to come?
I guess that’s the question no one wants to think about.