Chairman’s Views

Renewed Bond Sell-Off Driven by Continued Strength in US Labour Market

As at 12 July 2023

Author: Gavyn Davies, Chairman

Main Points:

  • Global bond yields rose significantly in most government markets last week. US yields are now close to 15-year highs.
  • The latest sell-off seems to have been triggered by a large upside surprise in the ADP (employment) data in the US, followed by stubbornly firm data on average earnings in the monthly employment release for June.
  • Seen in a slightly longer-term context, last week’s rise in yields has continued the pattern since April, when the markets began to accept that the SVB-related shock in the regional banking sector would not cause an imminent recession.
  • The Fed now seems willing and able to deliver at least two further 25 bps increases in policy rates this year, given strong labour market data and broadly stable core inflation. This is now largely priced into the markets.
  • The recent global bond sell-off has been much larger in the UK than in the US, Japan, or the EU. This reflects much worse inflation data in the UK, forcing the Bank of England to react sharply.
  • The UK represents a special case with further upside risks to short rates and bond yields. Meanwhile, in the US and EU, central bank guidance will remain somewhat hawkish but will not deliver a further large bearish shock to bond markets of the type seen recently.
  • Our asset allocation models remain heavily underweight bonds relative to cash, driven in part by the extreme inversions in yield curves. These models do not see higher yields as a buying opportunity, yet.
  • We are watching carefully to determine whether risk assets will react to the hawkish monetary policy shock, which could drag equities into trouble. This has not happened so far.
  • As noted here last week, a clash between a slowing economy and hostile monetary policy seems far more probable in the EU than in the US, at least for now.

  1. Rising government bond yields last week seem to have been triggered mainly by reports of continued strength in the US labour market. The ADP employment series for non-farm private employment rose by 497,000 in June, the largest monthly increase for over a year. Furthermore, robust growth in employment was reported throughout the economy, including in the supposedly weak goods sector. The official BLS payroll employment survey rose by “only” 209,000 but average hourly earnings jumped by 0.4%, showing little sign of wage deceleration. Finally, initial jobless claims rose to 254,000 last week, still close to recent cyclical low points.
  2. Although this collection of labour market evidence could be viewed as broadly in line with the FOMC’s expectation of a gradually cooling labour market, it certainly is not consistent with the idea that a recession is just around the corner. The Fulcrum nowcast for the US remains close to 2%, just above the economy’s trend growth rate, and PMI and ISM business surveys in the services sector remain strong. The 3.6 points increase in the services ISM balance for June, along with the 5.2-point rise in the Michigan consumer sentiment index, were both crucial factors in convincing the market that weak manufacturing activity would not be sufficient to drag the economy into a downturn.
  3. Recent US activity data have been followed by more hawkish guidance from the leadership of the Fed about their intentions to raise policy rates further in the remainder of this year. In successive statements since the June FOMC meeting, Chairman Powell has sounded more confident that the economy is strong enough to cope with at least two further rate hikes this year, and possibly even three. Furthermore, the higher-for-longer theme about rates probably extends into next year, according to some members¹ of the Committee. This is still not fully reflected in the market’s central expectation for rates but there has been a definite shift in that direction as perceived recession risks have fallen.
  4. Although these changes in opinion about US front end rates have clearly been important for global bond markets, the rise in US rates in recent months has not been exceptionally large in an international context. In the latest 3-month period, 10-year government yields have risen by 55 bps in the US, compared to 31 bps in Germany and 121 bps in the UK, where inflation risks have increased appreciably. Yields in other English-speaking countries including Canada, New Zealand and Australia have also risen rapidly, by 63 bps, 79 bps and 95 bps respectively².
  5. Gradual increases in US and EU bond yields have reflected only moderately hawkish central bank guidance about policy rates, but yields have nevertheless touched levels not exceeded in the past decade. In general, these changes in global yields have been driven by the expected stance of monetary policy, compared to what is priced in the market. Furthermore, the changes have been in line with variations in economic fundamentals, concerning recession and inflation risks in the different economies. In retrospect, then, the behaviour of the global bond market has not been particularly “surprising,” given incoming news. Bonds now seem to be fairly priced from a short-term trading point of view, pending a change in the flow of data.
  6. It is important to note that all of the increase in nominal yields has occurred because of a rise in real yields in the inflation-protected bond market (i.e., TIPS), with minor changes in breakeven inflation rates. There is therefore no noteworthy evidence that bond markets are beginning to doubt the determination of the central banks to return inflation to rates close to their 2% targets over the medium term. Higher bond yields have reflected tighter real monetary policy, not higher inflation expectations. Equity markets have been resilient to this development, so far.
  7. Yield curves are now so inverted – in fact, more inverted in the US than at any time since the early 1980s – that they are not likely to invert much further if short rates rise again. This implies that upside risks to global bond yields therefore comes down to one simple question, which is whether the Fed and other major central banks will once again surprise markets by tightening policy by more than indicated in the forward markets. Higher forward short rates would then inevitably drag long bond yields higher. However, we do not expect this to happen in the rest of 2023. The UK is a possible exception to this general conclusion, and we also note that a relaxation of Japanese yield curve control is conceivable at the upcoming BoJ Policy Meeting on 27-28 July. This could impart an upward shock to JGB yields if it occurred.
  8. What about the longer-term role of bonds in asset allocation portfolios? With US yields now at 15-year highs, and EU yields at 12-year highs, it is natural to ask whether these yields should now be locked into portfolios. Our Fulcrum Macro Allocation and Risk System (MARS) model continues to view this as premature. The current extreme inversions in yield curves indicate that carry that is available on long bonds is still at historically negative levels, implying that excess returns from duration may remain abnormally low, even after short rates have clearly peaked. The MARS model recommends long bond weights of only 20%, compared to a strategic target of 40%.
  9. The MARS recommended weights, compared to strategic targets, are shown in the graph overleaf.

Asset Allocation Summary

Source: Fulcrum Asset Management

About the Author

Gavyn Davies

Gavyn Davies is Chairman and co-founder of Fulcrum Asset Management. Prior to Fulcrum, Gavyn was as an Economic Policy Adviser to the British Prime Minister (1976-1979) and a member of H.M.Treasury Independent Forecasting Panel (1992-1997). He was the Head of the Global Economics Department at Goldman Sachs from 1987-2001 and Chairman of the BBC from 2001-2004. Gavyn graduated in Economics from Cambridge followed by two years of research at Oxford and he is also a visiting fellow at Balliol College, Oxford.

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