Insight  |  November 13, 2023

Muzinich Weekly Market Comment - November 13th 2023

Weekly Update: The Residual

Markets delivered mixed results last week. Government bond curves flattened (with the front-end underperforming), corporate credit markets performed strongly, and credit spreads were tighter in both investment grade and high yield markets. Most equity markets finished the week within a 1% range of where they started; commodities underperformed, moving lower across the board as more weight was given to an outlook focused on weak global growth vs. one focused on supply constrained geopolitics.   

The Reserve Bank of Australia increased policy rates (as expected) by 25 basis points (bps) to 4.35%. This was accompanied by dovish language. China dropped back into deflation as consumer prices in October fell by -0.2% year-over-year with falling food prices and subdued domestic consumption to blame. In our view, this leaves more room for the central bank to add stimulus before year end. This week investors will closely monitor the expected meeting between Xi Jinping and Joe Biden to gauge China-US relations. 

In Europe, the International Monetary Fund (IMF) warned against prematurely celebrating the defeat of inflation1. The IMF stated that historically it takes an average of three years to bring inflation back to lower levels, and that a failure to finish the job could result in another round of monetary tightening, potentially reducing growth by as much as 1%. This warning aligned with the European Central Bank’s September consumer survey released last week which showed inflation expectations over the next 12 months increasing from 3.5% to 4%. On a slightly more optimistic note, the IMF also forecasts that Europe is heading for a soft landing; it is not expecting an extended recession across the region. For the Eurozone, the IMF’s outlook for growth is 0.7% for this year and 1.5% for 2024.   

In the US, the key data release was the third quarter Senior Loan Officer Opinion Survey, which reviews bank lending standards which have been a good lead indicator of economic growth. The survey surprised the economic bears, showing an improvement in banks’ willingness to lend compared to the second quarter. The net balance (the tightening lending standards of banks minus the loosening lending standards of banks) fell from 50.8% to 33.9%. Lending conditions remain restrictive by historic standards, but we believe further loosening would be encouraging and would help support growth going forward.   

The 10-year US government yield was basically unchanged for the week; this makes sense if we consider the calendar-lite week for economic data with the Federal Open Market Committee (FOMC) on hold for Friday’s national holiday (Veterans Day). However, this does not show the daily battle investors fought to set the equilibrium yield for the 10-year Treasury; the daily swings in yield have been huge, averaging 12bps. What is to blame? The most cited offender is the term premium.  The term premium is an elusive concept—it is defined as the difference between long-dated yields and the expected path of short interest rates over the same tenor. That is, the yield difference investors demand to own a long-dated bond instead of continuously rolling over very short-dated securities to the same maturity. The glaringly obvious problem with this definition is that no one can predict the expected path of interest rates over an extended period (e.g., for the next 10 years). The Minneapolis Fed President Neel Kashkari best summed up the term premium by stating that it’s “the economists’ version of ‘dark matter’—it’s the residual of all the stuff we can’t explain2.” So, it is the premium that investors seek to protect themselves against unforeseen risks. With the FOMC on hold, even alluding to the fact that the rising term premium is doing the monetary tightening work for them, what do US bond investors fear?

Sticky inflation. Tight labor markets, multiple supply chains or deglobalization, alongside the transition to cleaner energy. There is great uncertainty whether the FOMC can bring inflation back down to its 2% target. Or, in fact, if the 2% target is appropriate.  

Government fiscal responsibility. For the fiscal year (FY) 2022, the US federal deficit was US$1.375tn. This has significantly deteriorated in FY 2023, with the US Treasury estimating that the deficit grew to US$1.7tn. With next year as an election year, and the incumbent administration not certain to win, only a brave forecaster could expect the administration to tighten its fiscal belt, leading to expectations of further deterioration.

Excessive supply of bonds. The estimated gross government bond supply bond is US$4.16tn for 2024; a pickup from US$3.3tn in 20233. With the FOMC quantitative tightening programme in effect (selling down their supply of bonds), and other natural buyers of US government bonds now selling to defend their currencies (e.g., China and Japan), the risk of a supply-to-demand imbalance is possible. Maybe this week’s US$24bn 30-year auction was a warning; pricing in a yield +5.3bps above the indicated pre-sale yield, only one other auction in the last decade has priced so wide of its advertised yield. 

What we can conclude is that for government bond investors, the unforeseen risks are skewed towards increasing the term premium—and by historic standards, the term premium is still at extremely low levels (see Chart of the Week). It may also be the underestimation of this premium that forces the FOMC to cut rates—as the term premium rises further, restricting the economy and causing it to fall into recession. The central bank’s track record of soft landings is not great.  

Chart of the Week: The Adrian, Crump & Moench 10 Year Treasury Term Premium

Source: Bloomberg, as of 10th November 2023. For illustrative purposes only.

1.Associated Press, 8th November 2023

2.Bloomberg News, “Dark Matter” Bond Metric Mesmerizes Wall Street and Washington, 9th November 2023

3.Goldman Sachs, US Treasuries Supply Outlook, 22nd August 2023


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