Bond market bulls remain in charge, but for how long?

The key theme as we move through 2024 is that bond market bulls are out in force and continue to price in expectations of a March rate cut for the Federal Reserve, and early rate cuts for the ECB and the BOE, seemingly without taking notice of geopolitical tensions, threats to global supply chains, election risks, a wave of extra Treasury supply and some fairly hawkish talk from several Fed officials. There are many unknowns in the market, such as the trajectory for inflation, yet the bond market seems to be ignoring these risks and ploughing ahead with their view that all will be well, and the Fed will cut interest rates in March.

Bond market traders and investors are meant to be the sensible ones, however, as we move through January, the FX market is fairly neutral, with no clear driver for currency markets, while stock markets excluding Japan, are all lower so far this year. There is no unifying theme across asset classes, economic data has been bouncy, and the risk is that the bond market is too fixated on cuts to interest rates.

Are traders too complacent?

US 2-year Treasury yields fell 26 basis points last week. The downside move for yields escalated after the weaker than expected producer price data from the US for December. This triggered hopes that pressure in the US inflation pipeline were easing, and we could see lower CPI from here. However, as the pick-up in December CPI has shown, the sharp falls that we have seen in CPI could be behind us, and it may be gentle declines in inflation from now on. There is also a risk to the upside for later this year, as attacks on commercial vessels in the Red Sea has forced a major de-tour for the world’s largest shippers, who are now having to take their containers full of spring goods destined for the west around the horn of Africa. That is costing more in transport costs and also could lead to delays, product bottle necks and pent-up demand. We saw what that did to inflation during the pandemic. While we do not think now is time to worry about inflation pressures, the recent developments in the Red Sea are a warning sign not to get too complacent.

FX view

The market has nearly fully priced in a rate cut from the Federal Reserve for March. There is a now more than a 75% chance of a cut, according to the CME Fedwatch tool, last week there was a 64% chance of a March cut. Expectation of a rate cut has not filtered through to other markets. The dollar has not fallen off a cliff so far this year, and last week the moves in the major dollar crosses were fairly minimal. There were losses for the commodity currencies and the yen vs. the USD, and gains for the Norwegian krone. EUR/USD and GBP/USD were virtually unchanged.

Stock market view

In the stock markets, US markets picked up sharply last week. The S&P 500 rose 1.86% and the Nasdaq was higher by more than 3%. Earnings news was mixed, which suggests that lower bond yields helped to boost the mood of investors. The prospect of lower interest rates can help boost the attractiveness of tech stocks, as it lowers the discount rate for future revenues. US stocks may have interrupted their 9-week winning streak with losses two weeks ago, however, we will watch this week to see if stocks follow the path laid by the bulls, and continue to move higher, as euphoria drives market moves.

Why we are watching the US yield curve

We also pointed out last week that the Vix remains at historically low levels, and Wall Street’s fear gauge continued to fall last week. This is worrying for some, since the Vix does not stay low forever, but it is also indicative of bullish market sentiment that could fuel further gains for stocks. Another market indicator could support an extension of bullish sentiment: the US yield curve. Since July 2022, the 10-year – 2-year US Treasury yield curve has been in negative territory, which is a warning sign that a recession is imminent. The recession never materialised, and stocks mostly ignored the inverted US yield curve, especially during 2023’s bull market for US stocks. Now that the yield curve is steepening again, and is only 18 basis points away from 0%, could this fuel more bullish sentiment as it is a sign that there won’t be a recession? The market ignored negative economic signals from the bond market in 2023, will it pay attention to positive ones in 2024?

Taiwan kicks off big year for elections

Elsewhere, Taiwan elected the incumbent and anti-China Democratic Progressive Party back into office on Saturday, for an unprecedented third term. However, it was not all good news for the DPP, as they did not manage to win a legislative majority. This could hinder their ability to advance their anti-China agenda. Although there is little prospect of closer ties between Taiwan and Beijing, President Xi’s options in Taiwan are also constrained by China’s own domestic plight – its severe economic downturn and its beleaguered property sector. Thus, there could be an uneasy truce between China and Taiwan as both countries have their own domestic challenges to deal with.

UK inflation preview

Economic data worth watching this week including UK labour market data, UK inflation for December and UK retail sales, along with some Fed speakers and key US Treasury auctions. There are also more earnings releases, including Netflix later this week. The UK is expected to see inflation fall back to 3.8% in December from 3.9% in November. This could further highlight how the UK is shedding its mantle of having the worst rate of inflation in the G7. UK CPI is expected to fall below France’s level for the first time in 2 years! Added to this, UK core inflation is also expected to decline below 5% for the first time in 2 years. If inflation does decline as expected, we do not expect any major change in rate cut expectations for the BOE. Right now, there are already more than 5 cuts priced in for the BOE this year, with the first rate cut coming in May. If inflation is more stubborn than expected, this first-rate cut could be pushed back. However, if inflation falls as expected, then we could see limited upside potential for GBP.

More pain for bitcoin

Bitcoin’s ETF status did not help the crypto currency to extend gains last week. It fell more than 14% after the announcement that the first ETF had been granted approval by the SEC to start trading, and has extended losses this weekend to $42,274 at the time of writing. This appears to be ‘buy the rumour, sell the fact’ behaviour from the market. We will also need to wait to see how popular the ETFs are, and crucially who is buying them, before the Bitcoin price stabilises as the market adjusts to crypto existing in a regulated world.