Bond markets expect the US economy to defy historical precedent and avoid recession.
August’s global and domestic macroeconomic trends extended into September. Global rates shifted higher across the curve and equity markets continued to generate negative returns on expectations that the US central bank will keep its policy rate higher for longer, and possibly raise it again by 25bp before the end of the year. While leaving the policy rate unchanged at 5.25%/5.50% in September, the FOMC has cautioned that it remains concerned about inflation, which is above its 2.0% target rate, and believes labour markets are indicating a recession would be unlikely. The real policy rate is above estimates of the neutral rate and will remain restrictive until inflation moves to target. Below trend growth is likely to be required in order to achieve this.
Indicative of market expectations that growth and inflation rates will slow from current levels, the US yield curve remained inverted in the third quarter, but flattened from May’s -175bp (3-m t-bill versus UST 10-yr) to -87bp at the end of September. While we believe it is still unclear what will continue drive the dis-inversion i.e. a recession (hard landing), or a re-emergence of inflation (a soft or even no landing), growing consensus around the latter scenario has driven market performance over the past quarter; the back end of the curve rose on expectations that the economy would not slow into recessionary type conditions and the front end priced in a shallower cutting cycle. The UST 2-yr rose 15bp to 5.0%, and the UST 10-yr yield rose 73bp to 4.57%. TIPS (10-yr US real rates) rose 61bp, to 2.23%, indicating a slight increase in longer term inflation expectations.
Under a soft-landing scenario, US inflation is likely to fall below 2.0% before ‘normalizing’ to between 2.0% and 2.5%. Assuming a neutral real rate of 1.0% to 1.5%, the US repo rate could fall to between 3.0% and 3.5%. The spread between the 3-mth t-bill and US 10-yr has averaged +170bp since 1981, which implies that at the end of 3Q23, the 10-yr UST was priced for this scenario (4.7%). If the scenario continues to play out, the UST 10-yr could rise further to 5.2% (3.5% + 1.7%). The SA local bond curve has followed the US curve and is also largely priced for a soft-landing scenario but could steepen further.
If markets are correct, and the US economy finds its goldilocks equilibrium, in which inflation and growth are neither too hot nor too cold, this would be an unprecedented outcome in the face of aggressive rate hikes by the Fed and a fall in CPI inflation from a peak of 9.1% in June 2022 to 3.7% in September.
We are concerned that markets are not pricing the potential of a hard landing, which we believe is still the most likely outcome. US economists are raising the alarm that several leading and co-incident economic data releases are increasingly indicative of a US recession. We expect that in the coming quarter, data releases will show more substantial weakness in US consumer and corporate health, generating increased two-way risk and volatility as markets overact to high frequency data releases. If the US economy is unable to defy history, and a hard landing looks to be inevitable, considering current positioning we expect global yield curves would adjust abruptly, bull flattening as both the long and short ends fall.
SA’s financial markets are being driven primarily by US and EU markets but are also constrained by elevated domestic risks, as evidenced by SA’s 10-yr CDS spread widening 17bp over the quarter, to 380bp. There seems little consensus about what to expect from Eskom and the medium-term budget, and elections will loom large as we head into 2024. National Treasury reiterated its intention to consolidate and reduce the budget deficit through expenditure cuts, publishing a list of key priorities in September and highlighting the political nature of the trade-offs that must be made. Unfortunately, even with budget cuts and potentially an increase in VAT, it is apparent that without stronger growth SA’s fiscal path is unsustainable. In this context, we note that structural sovereign risks constrain the extent to which domestic monetary policy can be accommodative. SA’s real policy rate ended the quarter at 3.50%, which is highly restrictive relative to real growth expectations of 0.5%. As with the FOMC meeting, SA’s MPC meeting in September opened the door to further hikes.
Potential market implications of the attack by Hamas on Israel
Any increased probability of an escalation which includes other countries direct involvement in the Israel/Palestine conflict would see risk aversion trades play out: dollar strength, lower UST yields, higher gas and oil prices, higher gold prices and generally a more persistent bid for safe-haven assets. Higher oil prices would drive inflation higher and our view is that this would accelerate the current consumer slowdown in the US. Although this would put some pressure on the Fed to hike another 25bp in the next quarter, it should also increase the chance of a hard landing and a sharp fall in rates.
Absent an escalation the market impact is likely to be transitory for all other than the civilians of Israel and Palestine, where the cost will be unavoidably great.
An escalation scenario
The surprise attack on Israel comes at a time of global geopolitical sensitivity and weakness for Israel. In terms of timing, it is also useful to view it as an extension of the geopolitics emanating from Russia’s invasion of Ukraine. This increases the chance that it extends beyond Israel and Palestine.
The channels of disruption to economies and markets were significant in Ukraine/Russia as Ukraine is a global supplier of wheat and Russia is a major oil exporting nation (c.11m bpd) and Europe’s primary gas supplier. The war prompted Europe to reconfigure its global gas and oil supply arrangements. From this perspective it is important to note that Israel has been in negotiations with Turkey about gas exports to Europe along with corridors for trade from Asia, so as to avoid Russia.
In addition, Israel, the US and Saudi Arabia have been in negotiations which would see Saudi Arabia given security guarantees by the US, in exchange for Saudi Arabia advancing its relations with Israel, thereby cementing a more West-friendly bloc in the Middle East. This is at odds with the agendas of Iran and Russia, especially if Turkey were to join. It appears from media reports that Russia was part of the planning of the attack, and it is known that Iran is a primary backer of Hamas. It seems that the attack has been successful with respect to halting the talks between Saudi Arabia and Israel.
It is interesting to note that at present, Egypt has not involved itself in the conflict – it has not opened its border with Gaza to allow civilians to escape and find refuge.
With respect to the US, the attack has bearing on its domestic politics: The relationship between Trump and Saudi Arabia was far better than the relationship between Biden and Saudi Arabia. Biden’s giving Iran $6bn disrupted the delicate power balance in the Middle East, which is largely kept in check by Saudi Arabia, as the most powerful political player. Saudi Arabia made their displeasure known and the fallout has had implications for the oil price. The $6bn is seen to have come at an opportune time in terms of funding the recent attack. Trump is using this opportunity to highlight Biden’s naivety. Trump is also a vocal supporter of Israel.
Iran is also a material oil producer (c.3m bpd), and increased sanctions and/or an escalation of the war to include other countries would have ramifications for the oil price as well as certain companies (such as MTN) should Iranian sanctions expand. Under this escalation scenario the market impact would be protracted, on fears of a full blown war in the Middle East.
As highlighted at the beginning, if a Middle East war became a scenario, geopolitics would point to it becoming an extension of the Ukraine-Russia war, risking the increased probability of a broader world war.