Interest Rates, Yields, Currency and Inflation

Fed expectations in line with the latest employment and CPI data… A new CPI reading on Thursday is expected to determine how much more aggressive the Fed will be with its most contentious rate hike plans in decades. The resulting economic release will be of even greater importance after the Labor Department’s September jobs report on Friday suggested that officials have more room for growth.

The US economy added 263,000 jobs last month, a moderation from the previous edition, but still a strong hiring figure as the unemployment rate dropped to 3.5%. The weaker-than-expected decline in employment earnings dashed investors’ hopes that FOMC members could leave monetary tightening sooner than expected.

“In our view, the persistent strength in hiring and the drop in the unemployment rate means the Fed is unlikely to turn towards a slower rate of rate growth until we have clearer evidence of slowing employment growth,” Bank of America analysts said in a note Friday. They added that the agency expects a fourth 75 basis point increase in November.

And this week’s inflation reading could support such a move next month. According to Bloomberg forecasts, the headline consumer price index for September is expected to moderate slightly year-on-year and fall to 8.1% from 8.3% in August, although monthly inflation is also expected to be higher than 0.1% in the previous month. Momentum is expected to rise 0.2%.

All eyes will be on the “core” component of the report, which extracts the volatile food and energy categories. On the core CPI side, economists surveyed by Bloomberg expect a year-over-year rise of 6.3% to 6.5%, but also forecast a monthly increase, which could fall to 0.4% month-on-month from 0.6% in August.

Why is the ECB acting so aggressively, why shouldn’t it be so aggressive? The European Central Bank gave a strong signal by raising interest rates by 75 basis points, taking a proactive stance in the face of high inflation. But consumers are already grappling with high energy bills, and as a recession approaches, the bank risks cutting the economy too far with aggressive rate hikes.

The most immediate and significant impact of the ECB’s hawkishness has been high interest rates, rising roughly 1% in six weeks along the yield curve, and real returns, or nominal returns, have been lower than expected inflation as inflation expectations have actually fallen over the same period.

This created a material headwind for the eurozone economy and its investors. Higher real returns act as a brake on economic activity, making consumption and borrowing more expensive. And for investors, a higher real return erodes their returns by lowering the valuations of risk assets.

Of course, to some extent, the ECB wants to slow down the economy by reducing demand and tighten financial conditions for investors. The risk, however, is that he simultaneously forecasts worse than expected how much growth has slowed due to the energy crisis and how long inflation will remain high.

Under these conditions, it can hold rates very fast, very high, and there for too long. We are concerned that this risk is escalating as the ECB’s latest economic growth forecasts and the inflation outlook appear relatively high.

 The German bond situation

German Rates and Bonds

German government bond yields fell on Monday after booms shook the Ukrainian capital of Kiev and other major Ukrainian cities, triggering a shift to traditional safe-haven assets such as government bonds.

According to Mizuho bond strategist Evelyne Gomez-Liechti, a host of new export controls also weighed on the sentiment, including weak services data from China, renewed COVID concerns in the country, and a measure by the Biden administration to cut China from certain semiconductor chips. was putting pressure. “The Crimean bridge and blasts really didn’t fit the risk sentiment. These are probably the driving forces that hurt the sentiment and gave some strength in the bond markets,” Gomez-Liechti said.

Gilt returns in the UK

UK Rates and Bonds

On September 28, the Central Bank’s Financial Stability Committee announced a two-week emergency purchase program for long-term UK government bonds to restore order in the markets and protect liability-based investment (LDI) funds from imminent collapse: It held 8 auctions with purchase offers of up to £5 billion and purchased bonds of around £5 billion: “The bank is ready to use this unused capacity to increase the maximum size of five auctions remaining above the current level of up to £5 billion available at each auction.”

The bank will also launch a Temporary Extended Collateral Repo Facility (TECRF) that will allow banks to ease liquidity pressures on client funds involved in recent market volatility. After the unprecedented rise in Gilt yields last month, LDIs holding substantial gold and predominantly belonging to final payroll pension plans were receiving margin calls from lenders. “As part of these operations, the Bank will accept collateral eligible under the Sterling Monetary Framework (SMF), including index-linked gold, as well as a wider range of collateral than is normally appropriate under SMF, such as corporate bond collateral,” the Bank said.

Third, the Bank said it will be ready to use regular Indexed Long-Term Repo operations every Tuesday to further ease the liquidity pressure on LDI funds, allowing market participants to borrow BOE cash reserves for less liquid assets for six months. “This permanent facility will provide banks with additional liquidity against SMF eligible collateral, including index-linked gold, thereby supporting their lending to LDI counterparties,” the bank said.

CBP Quilvest adviser Bob Parker told CNBC on Monday that the new measures will calm market concerns in the short term, but “a number of big problems” will remain through 2023. “The first big problem is obviously that the Bank of England will have to raise the base rate even higher – the consensus is that as we head into 2023, base rates of plus or minus 4.5% are the central case,” Parker said.

Parker argued that UK regulators “underestimated” the leverage on these LDI funds, exposing them to collateral obligations and margin calls when yields spiked. Gilt forecasts yields to rise further, the 10-year already up more than 100 basis points from last month. “The reality is that while inflation is hovering around 10% for at least the next few months, we have negative real returns in excess of 5%,” Parker said.

 JGB returns in Japan

Japanese Rates and Bonds

Japan’s 10-year government bonds were flat on Friday and kept yields just below the upper limit of the Bank of Japan’s tolerance band, despite strong US Treasury bonds. The 10-year yield remained at 0.245%, just below the 0.25% cap imposed by the BOJ through its yield curve control (YCC) policy.

The widening gap between interest rates in the US and Japan has added to sales in the yen this year, putting pressure on markets in the world’s third-largest economy. So any slowdown in the Fed’s rate hikes will likely ease some of the pressure on Japanese assets.

In a research note published Thursday, JPMorgan analysts Ayako Fujita, Takafumi Yamawaki and Benjamin Shatil wrote that they expect the BOJ to downsize its YCC policy from March next year, with a 0.25% increase seen as the most likely option. Analysts said, “Based on the assumption that the BOJ has raised its 10-year return target to 25 basis points in March 2023, it currently expects 5-year, 10-year and 20-year JGB returns to rise to 0.1%, 0.4% and 1.2%, respectively.”

Currency and interest rate uncertainties in line with war and supply chain problems… In line with the Fed’s rate hikes, the dollar has strengthened against most currencies around the world, as a stronger US dollar will mean buying commodities will become more expensive for those using other currencies.

Experts say that before the Ukraine-Russia war, which caused a sharp increase in wheat prices, global food prices were already rising due to disruptions in the supply chain and harsh weather conditions. Now, high labor and energy costs, which continue to feed high food prices, have exacerbated the problems.

This raises the question of whether the decline in global commodity prices will continue, given the many uncertainties the world is facing.

This is part of some evidence that global inflationary forces are beginning to loosen even as they continue to rise. Prices for a number of global commodities are finally starting to fall from their peaks. Oil prices fell and prices of key agricultural commodities also pulled back. Over time, we should see lower input and shipping costs and food inflation begin to decline. Supply bottlenecks have also begun to improve.

Global supply bottlenecks are starting to ease but remain high… Note: “ships in queue at Los Angeles and Long Beach” is an “end of period value… “Harper Petersen shipping cost index” averaged weekly data

Global manufacturers report that lead times are still longer than usual, but they are shortening and input cost pressures are easing. Global shipping costs also fell from extraordinarily high levels.

These signs of improving global supply chains are encouraging, but we cannot count on easing the pressure on global prices to keep inflation down. At the very least, it will take time for the improving global factors to filter out for inflation. And the recent appreciation of the US dollar will offset some of this global development by making US goods more expensive for everyone.

Conclusion? Investors have a tough combination of factors to consider in Europe, with the risk of a potential recession, increased geopolitical risk, and now increased over tightening by the ECB. In addition, the slowdown in growth and the global backdrop of tighter monetary policy, as well as the lag in which monetary policy affects growth and inflation, further increase this risk.

Germany’s 10-year government bond yield edged up to 2.2% on Friday, approaching an 11-year high of 2.352% at the end of September after a stronger-than-expected US jobs report pointed to a tight labor market.

The minutes of the European Central Bank’s monetary policy meeting this week suggested that policymakers will continue to raise interest rates to combat inflation even as the region faces an economic downturn. In September, the Central Bank increased interest rates by an unprecedented 75 basis points and signaled rate hikes in the upcoming meetings. Money markets are pricing in another 75 basis point increase in interest rates, with 125 basis points tightening until the end of the year at the October meeting.

There is also significant uncertainty about the evolution of global supply chains and commodity prices. The global economy continues to deteriorate drastically due to the effects of the pandemic and the war in Ukraine. It is not easy to predict international price movements and the global inflation picture can change rapidly.

Kaynak Enver Erkan / Tera Yatırım
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