July’s bull market for U.S. and global stocks appeared to end last week, with the S&P 500 down 2.3% last week and the NASDAQ down 3.2%. The FTSE 100 fell 4.2%, while the Euro Stoxx 50 was down 3.6%.
At the risk of over-simplification, the clearest explanation appears to be a steady rise in global bond yields over much of last week, that included Treasuries, gilts, bonds and Japanese Government Bonds (JGBs).
Higher ‘risk free’ yields increase the relative attraction of risk-free assets, such as government bonds, over equities and other risk assets. They also reinforce the ‘higher for longer’ interest rate theme, which could reduce profits growth expectations for stock market investors.
Note, however, that bond yields fell on Friday, in response to July labour market that is best described as ambiguous.* New non-farm payroll growth was weaker than expected, at 180,000, but the fall in the unemployment level to 3.5%, and 4.4% annual hourly pay growth, suggests a still-tight labour market.
So why did bond yields rise for most of last week?
The global rise in bond yields wasn’t caused by the recent rate hikes from the Fed, ECB and, last week, from the Bank of England. These were in line with expectations and the accompanying statements on the outlook for inflation and interest rate policy were unsurprising. It appears increasingly likely that central banks are close to peak interest rates (and perhaps at that point in the U.S.), thanks to falls in previously stubborn core inflation.
Rather, the increase in bond yields has been attributed to two very different surprises.
First, from the rating agency Fitch, which last Tuesday downgraded U.S. government debt, from AAA to AA+.** This followed the downgrade by Standard and Poor in 2011. Fitch cited both debt and ‘governance’ i.e., political, reasons.
Since no country that prints its own money need default on local currency debt, Fitch’s downgrade may have had less impact had it not coincided with an unfortunately timed announcement from the Treasury. It announced an increase in the amount of long-dated Treasuries issued this year, due the growing gap between tax receipts and government expenditure, appearing to confirm any fears raised by the Fitch announcement on over-supply.
Bank of Japan
Second, the Bank of Japan. The BoJ ten days ago eased its yield curve control (YCC) policy. It raised the maximum yield on the 10yr JGB that will be permitted before it intervenes, from 0.5% to 1.0%.*** The 10 yr. yield climbed 20bp, in response, and is currently at a seven-year high of 0.63%.
The still-low yields on JGBs make them unattractive to many global investors. After all, the 10yr Treasury is yielding 4.1%, and the 10yr U.K gilt 4.8%. But not necessarily to Japanese investors, who fear that even small rises in JGB yields could lead to an appreciating yen and to currency losses on overseas investments (as the cost of hedging the yen rises).
An appreciating yen might then encourage more selling of overseas investments, not just bonds. This cycle could feed on itself, with prices for financial assets elsewhere falling in response.
Japan was the largest foreign holder of Treasuries at the end of 2022 (followed by China), and in the first quarter of this year Japan bought more Treasuries than in any previous quarter, worth $68 billion worth. An exodus of Japanese investors could have major repercussions on Treasury prices, with yields likely to rise.
Of course, the Bank of Japan is nervous of slipping back into deflation -which it has battled against for nearly 30 years- and may intervene to stop an appreciating yen, and higher borrowing costs. This might trigger a return of deflation. It could prevent this by reducing the YCC policy rate, i.e., reversing the recent increases in the intervention yield target. But this would be politically difficult, with savers and consumers unsettled by the country’s 3.3% CPI inflation. The BoJ is treading a very fine line.
Investors should play the U.S. and global soft landing elsewhere
The soft-landing scenario for the U.S., and indeed the global economy, appears intact. There was nothing substantive last week that might challenge this broadly optimistic scenario.
However, and as we have written before, this does not mean U.S. stocks would be the best play on a U.S. and global economic recovery next year. Valuation arguments suggest European and Asian cyclical stocks over U.S. tech. Meanwhile, growing positive real yields on Treasuries and dollar cash offer investors a risk-free return that may be difficult to ignore.
Bank of England
On Thursday the Bank of England raised its key rate to 5.25%, as expected and left the door open for a further hike.**** At $1.27, it is unchanged over the week. It warned that interest rates are likely to ‘remain elevated’.
While it acknowledged that inflation is falling (it is currently the highest of any G7 country, at 7.9%), it said that progress bringing it down to the 2% target will be delayed because of persistent labour shortages and high energy costs. The Bank does not expect its inflation target to be reached until mid-2025.
The good news is that first, the Bank no longer expects a recession. This follows a similar improved forecast from the IMF the previous week. Second, mortgage rates appear to have peaked, with fixed term rates now starting to fall.
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