Stronger-than-expected job creation in the US, renewed doubts about inflation, the start of the earnings season, and geopolitical fallout from events in the Middle East. These factors have moved financial markets in recent days – but not necessarily as one might have expected.
US labour market – Job creation rebounds
Net job creation in September and upward revisions to the data for the previous two months have raised a big question: is there a slowdown in the US labour market? Non-farm payrolls came in at 336 000 in September – almost double the expected 180 000. Third-quarter monthly net job creation averaged 266 000, well above the second quarter’s 201 000.
The US Bureau of Labor Statistics’ household survey was less favourable, showing a stable unemployment rate at 3.8% (up from 3.5% in July) and a slight fall in job leavers at 12.7% of unemployed persons (down from 15.8% a year earlier). A high level for this indicator suggests employees are confident that jobs are plentiful meaning they could easily switch from one job to another.
The slowdown in the pace of wage increases (see Exhibit 1) appears to be part of the same trend: the labour market is gradually becoming less favourable to employees as supply and demand rebalance slowly.
Does the prospect of the labour market normalising explain the correction after the initial knee-jerk reaction that sent the yield of the 10-year Treasury note spiralling to above 4.85% and the 30-year yield to 5.05% in the wake of the job report’s release on Friday 6 October?
It could be so. But US bond market positioning adjustments before a three-day weekend may also have played a part. And the attack on Israel on 7 October prompted a flight-to-safety, benefiting government bonds at the expense of equities.
Really – ‘at the expense of equities’? Then what about the 3.2% increase in the MSCI AC World index in US dollar terms in the week that straddled those events, 4-11 October?
Market observers are used to the market’s occasional bout of ‘bad news is good news’ contrariness, when bad economic news is greeted by a rise in equities (or vice versa).
We are probably currently faced with another, equally specious type of reasoning: ‘a fall in bond yields (for whatever reason) leads to a rise in equities’.
According to the latest theory to join the club of circular reasoning the rise in long-term bond yields tightens financial conditions, which means that the US Federal Reserve may (or even must) respond by loosening monetary policy. Even if that seems logical, it’s not necessarily the case.
In a speech on 9 October, Fed Vice-Chair Phillip Jefferson illustrated the dilemma that the Fed will face in the coming months. Suggesting that the recent rise in real yields is a consequence of a stronger-than-expected economy that requires keeping monetary policy tighter for longer, he said: ‘I am also mindful that increases in real yields can arise from changes in investors’ attitudes toward risk and uncertainty. Looking ahead, I will remain cognizant of the tightening in financial conditions through higher bond yields as I assess the future path of policy’.
Where is inflation going?
The latest inflation news has been encouraging, showing a widespread slowdown of both core inflation and services prices. While some upside surprises remain possible, the dynamics of price increases have changed dramatically from 2022 and early 2023, raising hopes of an – albeit slow – return of inflation to central banks’ targets.
The International Monetary Fund devoted a chapter in its most recent World Economic Outlook report to the role of short-term inflation expectations on actual inflation dynamics. It appears to us that one of its key conclusions is that ‘improvements in monetary policy frameworks and communications can help lower the output costs needed to reduce inflation and inflation expectations, making it more likely the central bank can achieve a soft landing.’
The latest European Central Bank (ECB) consumer expectations survey found that, despite monetary policy tightening since July 2022, households anticipate inflation at 3.5% over the next 12 months (median point) with a wide dispersion.
The minutes of the September US Federal Open Market Committee (FOMC) meeting showed that a growing number of members are concerned about tightening financial conditions. They consider it important to ‘balance [the] risk of overtightening against [that] of insufficient tightening’ and that their discussions should now focus on ‘how long’ policy should be kept restrictive, rather than ‘how high’ policy rates should rise.
This roadmap implies that the Fed will ‘proceed carefully’ in the short term, with official rates likely on hold in November, but no rapid cuts after that.
Where are bonds going?
Explaining the upward pressure on long-term bond yields in September (+46bp on the US 10-year T-note yield; +37bp on the German Bund 10-year yield; +66bp on the Italian BTP yield) and early October is a tough task.
Is it a temporary phenomenon linked to adjustments in investor positions in this new transition period (end of the tightening cycle, revisions to market expectations of rapid policy rate cuts in 2024)? Or is it a reaction to a resilient US economy, with the usual contagion effect on European bond markets?
What cannot yet be ruled out is that the deterioration in bond yields in the third quarter stemmed from some investors seeking to obtain a better risk premium in the middle of uncertainty, as the Fed Vice Chair pointed out.
As for the growth outlook in the coming quarters, in our view the consensus seems a little too optimistic, ignoring the risk of a slowdown in activity.
Without even taking into account the specific risks in the US (auto workers’ strikes, end of the freeze on the repayment of student loans), a slowdown would normally be the ‘natural’ consequence of the brutal monetary tightening since 2022, whose effects seem to be delayed in this cycle compared to the past. The fact is, parts of the US economy such as the housing market are starting to suffer from rising interest rates.
In this context, we decided to keep our overweight position in the fixed income pockets of our diversified portfolios. Volatility may remain high in the short term, not only for technical reasons, but also because finding consensus in assessing the likelihood of the various possible scenarios is difficult.