Taking Stock: that ‘higher for longer’ feeling

The debt ceiling crisis may be about to be resolved. But another problem bedevilling the U.S. bond market, stubborn inflation, looks ever-more intractable. With this comes the prospect of ‘higher for longer’ interest rates from the Fed, the Bank of England and other western central banks. 

This may negate any positive impact on the financial markets that comes with a resolution to the debt ceiling crisis.

This Friday, we have May’s non-farm payroll numbers. The consensus estimate, reported by Reuters, is for around 193,000 new jobs to have been created. A significantly larger number, perhaps similar to the 253,000 jobs added in April, would add to inflation and interest rate fears. 

A debt crisis agreement? 

The good news, as we start the week, is that President Biden and House Speaker Kevin McCarthy, came to an agreement regarding the debt ceiling on Saturday. *

It is widely thought that the hard-core Republicans in Congress will be harder to win over than their Democrat equivalents. The House votes on the agreement this Wednesday. The U.S. Treasury looks likely to run out of cash next Monday, June 5. 

If party managers can persuade Congress to pass it, we can expect the U.S. yield curve to come down, as the risk premia dissolves. 

A fall in yield on the world’s key bond market will also support risk assets, with global stock markets and credit benefitting. Furthermore, by lowering the short-term rates available to money market funds, U.S. regional banks may find it easier to hold onto deposits and so the risk of another bank run is reduced.

Of course, the benefit to the U.S. yield curve will be uneven. Very short-dated Treasury bills have been the most sensitive in this crisis, since the risk of default on capital repayment on one-to-three-month maturities is much greater than the risk of default on, say five-year Treasuries.

However, longer dated bonds are not immune, since the coupons on all Treasuries may be defaulted on. This is presumably priced into the market and affects all maturities (except the zero-coupon bills) and which will unwind in the event of a deal.

Stubborn inflation

Agreement on the debt ceiling may be as nothing compared to the growing realisation, in Europe and the U.S. that core inflation appears stuck as relatively high levels. Fixed income markets have sold off as higher than expected U.S. and UK inflation has led to a (somewhat belated?) pricing in of the prospect of ‘higher for longer’ interest rates. 

The Fed’s core Personal Consumption Expenditure index (PCE) rose in April on a month-on-month basis, from 4.6% to 4.7%, driven by services. At the same time, U.S. consumer spending increased at a faster rate than expected. The market ended the week pricing in a 37% chance of another rate hike from the Fed, in June. The current target range is 5% to 5.25%.

Two-year Treasury yields, which are considered most sensitive to changes in interest rate expectations, jumped a quarter of a percentage point in the second half of last week, to 4.56%. Meanwhile 10-year yields ended at 3.81%, up a tenth of a percent over the same period.

In the UK, core CPI jumped from 6.2% to 6.8% over the same period, a blow for the Bank of England. The two-year gilt yield now stands at 4.48%, last seen in the giddy days of early October during Liz Truss’s prime ministership, as investors look to perhaps two more rate hikes in the current cycle. This would take the Bank of England’s key rate to 5.0%. 

Economists blame rising wages that, in turn, reflect a shortage of workers. As we discussed recently, this largely reflects a sharp rise long-term sickness and early retirement amongst the workforce in many western economies, and – in the UK – the impact of Brexit. 

The effect on the global economy of ‘higher for longer’ interest rates will be to increase the risk of recession and to adjust downwards corporate earnings expectations. 

Long term investors should remain invested in a broad range of assets

Investors should remember that portfolio volatility is significantly reduced over time by holding a large variety of investments. And that inflation parts of asset classes differently. For example, commodities and property often do relatively well during periods of inflation. Meanwhile, small cap companies may depend more on product innovation for revenue growth, than the broader macro-economic outlook.

* https://www.cnbc.com/2023/05/28/biden-mccarthy-reach-final-deal-to-prevent-default-now-must-sell-to-congress.html

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