Party season

Year-end is bringing festive cheer to investors!

As party season enters full swing, risk assets have continued to trade in a relatively festive fashion over the course of the past week. Robust economic data in the US has seen the Atlanta Fed Nowcast of GDP this quarter rise to 3.3%, with core CPI inflation also tracking at the same level.

The notion that the US is running as a 3+3 economy gives a bullish read on corporate earnings, and with the Fed still on a rate-cutting path, there seems plenty to feel cheery about. Equity markets in the US sit at their highs and credit spreads have narrowed to their tights for the year.

However, as with any good party, the nagging question is how long this can go on for and will there be a hangover in store when we wake up in 2025.

Over the past few weeks, bond and equity volatility has dropped markedly, though there is a sense that the current calm won’t be able to last. Momentum in stocks has been waning of late, and it is not clear where the catalyst will come to lead the next leg in any rally.

Meanwhile, we think that next week’s likely Fed cut will be the last in the current mini cycle. Assuming Powell lowers rates by 25bps next Wednesday, that will mark 100bps of easing during the past three months and, with the economy growing above trend and showing little sign of slowing, a pause appears well warranted.

Arguably, inflation risks could be more to the upside than the downside, if activity remains upbeat. Core price inflation ceased to decline during the summer and has subsequently looked to inch a little higher, rather than lower.

In this context, the Fed’s revised forecasts for growth and inflation will make for interesting reading next week, and all this before the Trump administration takes office and starts to enact its policy agenda.

We retain a slightly negative bias with respect to duration at the current time, with a short stance on 30-year Treasuries. Long-dated yields have moved somewhat higher over the course of the past week, with yields back at 4.5% and the 2/30 curve steepening to +35bps. With the Fed expected to cut next week, this will mean that for the first time in over two years, the long end will offer a positive yield pickup relative to cash rates, as the curve dis-inverts.

However, we remain inclined to see long bonds trade up to 4.75% in the coming month, and although a curve steepening view remains very consensual across market participants, we still think this is the right way to be positioned, with investors not paid term premium for owning longer dated assets.

At a time characterised by an overabundance of government bond supply, we strongly sense this needs to change in the months ahead. Otherwise, fiscal policy is only likely to continue to move in an ever more profligate direction, until it does so.

In Europe, the market backdrop remains relatively quiet. French political volatility has died down for the time being, now that Barnier has been ousted. As we have noted, new French Parliamentary elections can only be called next July and therefore we expect a period of limbo over the next few months. This has seen some short covering in French assets with 10-year OAT spreads into 75bps.

We retain a structurally bearish view on France and would target levels closer to 60bps as an opportunity to re-enter a short position, having booked gains on spread widening when the spread hit 80bps in the recent volatility.

Meanwhile, there is plenty of talk with respect to increased EU defence spending, but not a huge amount of action at the moment. EU prevarication risks meaning that decisions end up a day late and a dollar short, metaphorically speaking. There is also a sense that at a time when economies are depressed and budgets are constrained, there remains limited public appetite for military expenditure as the most pressing priority.

Budgetary constraints are also being felt in the UK. Higher borrowing costs and a stalled economy are worsening the UK fiscal position. Although Chancellor Reeves has cancelled a spring Budget and wanted to rule out further tax rises, the reality is that markets will dictate whether the government needs to do more to restrain the deficit, not the Labour leadership. We see UK inflation continuing to track above the BoE target and think that further rate cuts are unlikely for the foreseeable future.

We might also observe that a degree of inflation is becoming more normalised in inflation expectations and behaviour. On this point, it feels that buying breakfast in the morning is continually becoming more expensive and we have also wondered whether, in a largely cashless society, how clearly price changes are being noticed. For example, there may have been an element of shock in the past when a £20 note failed to cover the price of three beers at the bar, but nowadays there can be a tendency to tap without thinking and only realise in arrears that the pound in your pockets seems to be worth less and less, all the while.

As well as central bank meetings in the US, EU and UK, our attention will also be very much on the outcome of the BoJ meeting in Japan next week. Japanese data momentum has been solid, as shown in this week’s PPI inflation and Tankan survey releases.

We see little to be gained in the BoJ delaying a rate hike to 0.50%, noting that on its own analysis, they are falling further behind the curve and risking inflation momentum building on the upside. With wage growth expected at 5% in Q1’s Shunto round, we would argue that policymakers in Tokyo would be ill-advised to allow inflation to start to overshoot too much, as needing to correct for this could be exceptionally painful, in a country with elevated debt levels.

As we have highlighted for some time, we see a shifting of the tectonic plates underpinning the Japanese economy and, as inflation becomes more normalised, we have also been left wondering whether Japanese households, which have long sat on large cash balances, might be tempted to put this money into assets like stocks, which can deliver a real return and avoid an outcome that can see an erosion of net worth.

In FX, we continue to favour the dollar and, more generally, we feel that we are at a point where the opportunity set in currencies is more prevalent than has been the case for some time, against a backdrop of macro and political divergence. On the one hand, we look for the euro, Swiss franc, Chinese renminbi, and sterling all to weaken.

On the other hand, we are more constructive with respect to the yen, Australian dollar and US dollar. FX volatility remains relatively low, and we see scope for this to rise, as Trump takes office. In this context, it is interesting to note that Trump would actually like to see a weaker US dollar, yet his policies are likely to deliver the exact opposite.

This has led to some talk and speculation that he might seek to enact a Mar-a-Lago accord, to mirror the 1985 Plaza Accord, which sought to weaken the dollar following a period of excessive strength. This could become a future point of discussion but only, we think, if the dollar has appreciated another 10-20% from current levels today.

Looking forward

Next week marks the last real active week of trading in markets in 2024. Yet with important central bank decisions ahead of us, we don’t think that it is time to switch off just yet, even if volatility has been dropping in the past couple of weeks. We see market expectations for the Fed and ECB as largely fairly priced.

Yet we would continue to push back on a narrative expecting UK rate cuts and too few Japanese hikes, relatively speaking. The past several days have seen renewed hopes for further Chinese monetary stimulus, though in this respect, we continue to maintain a structurally downbeat view on the Chinese economy, until Beijing properly appreciates that it will struggle to export its way out of its problems and that it needs to be more prepared to boost domestic consumption.

Meanwhile, we would observe that December has historically tended to be a month when trending moves in FX markets can take place. Although the consensus appears to be moving dollar bullish, we suspect that the magnitude of positioning is still quite modest, with many investors wary of taking too much risk in FX, having been burned in this space over the past number of years.

We are more hopeful that there may be some presents to unwrap in this regard, over the next couple of weeks. 2024 has been a great run for owners of risk assets in general, but we think it is making more sense to think about leaving that party for now and looking to build up positions elsewhere.

Otherwise, in a week when I have caught some grief for not getting fully into the Christmas spirit on account of being too preoccupied with work, I thought that at least I could wear my favourite Christmas-themed jumper, ‘Baby, it’s Cold outside’! After all, it does seem that Chelsea are on their way back at last…thanks to Cold Palmer, of course!