Jupiter: Jupiter Merlin Weekly: Bonds Bounce, Inflation Confounds, Debt Rises

Bonds and the thundering herd  

“Yields drop as investors pile into government debt”. So reported the Financial Times on Friday 3rd February, the morning after the Bank of England and the European Central Bank had both raised interest rates by a half percentage point (and the day prior to that the Federal Reserve had moderated its aggression with only a quarter point increase).

Government bond yields had dropped sharply in response, the corollary of which was an equal and opposite upward move in prices, the “biggest one-day rally in Europe in years”, said the FT. The yield on the German 10 Year Bund (government bond) fell from 2.26% to 2.06%; in the US, the 10 Year Treasury yield dropped from 3.5% to 3.2%; in the UK, the 10 Year Gilt lost 34 basis points from 3.34% to 3.00%. And yet today, exactly two weeks later, 10 Year German Bunds yield 2.5%, US Treasuries are 3.9% and UK Gilts are at 3.6%; in all three cases, the yields are now higher than before the central bank announcements were made. If investors had been “piling into government debt” a couple of weeks ago, they must have been shipping out of it again in a significantly bigger way since!
What has happened to precipitate such pronounced volatility?  

Inflation: when entrenched views are confounded by the data  

The answer is familiar: diverging opinions on the inflation outlook and directly linked, the central banks’ narrative about future policy. This week’s inflation data has not been helpful to the camp which believes that if inflation rates rose in a straight line for most of last year, the reverse is as inevitable on the way down. January inflation rates declined in the US and the UK: so far so good. However, in both cases the progress was disappointing particularly against market expectations. Certainly, the headline rate of CPI (Consumer Price Index) in the US fell for a 7th consecutive month, but this time only from 6.5% in December to 6.4% in January (the market was hoping for 6.2% at worst); the UK saw a third consecutive monthly decline, but the pace of deceleration is relatively slow and CPI remained in double digits at 10.1% in January having been 10.5% in December; in Germany, inflation actually increased again, to 8.7% from 8.6%; France and Spain also saw inflation rates creeping up.

Different economies have their own dynamics. Nowhere is that truer than in labour markets. As we have said often before in these columns, while exposure to habitually cyclical and occasionally volatile commodity prices is a common and shared fact of life transcending national boundaries, labour and wages are largely driven by domestic factors and nominal wage rates tend not to fall. On this basis it is wage inflation which has a significant effect on the duration and stickiness of overall economic inflation. This week’s wages data for the fourth quarter of 2022 showed that annualised UK wage inflation was 6.7% (6.5% in Q3), reflecting a growth rate of 7.3% in the private sector and 4.2% in the public sector (while material improvements for employees, nevertheless they currently still represent falling real wages relative to the rate of economic inflation, particularly in the public sector reflected in the rising tide of industrial action).

The markets’ reaction is a tacit admission that, in the context of the common 2% inflation target shared between the Fed, the ECB and the Bank of England, the job of reducing inflation might be less straight forward than anticipated. It is logically true that interest rates must be closer to their peak now than a year ago when they were still virtually zero (or in Bank of England Governor Andrew Bailey’s terminology, “rock bottom”) in the US and the UK and negative in the eurozone. However, it remains a source of considerable uncertainty and division about how quickly interest rates will reverse and when that reduction will begin. From an investment standpoint, while it is tempting to try and be heroic making a conviction call on a particular outcome, in this situation with so few anchor-points of certainty, hedging one’s bets and keeping an open and flexible mind avoids the risk of painting oneself into a corner. 

US Treasury yields: complicated by the Debt Ceiling negotiations 

Added to which, in the US there is a short-term and unique complicating factor affecting US Treasury yields: the Debt Ceiling, the annual political argument in Washington about the permissible parameters of the government’s debt burden. This year there is the added frisson that with Joe Biden losing the House of Representatives, it is brewing into a first-class row with the Republicans politically gluing themselves to the road and refusing to budge until Biden meets their demands for lower public spending. The Debt Ceiling agreement carries a date stamp and in the absence of it being renewed in time, the government cannot continue spending and the public sector grinds to a halt: government employees don’t get paid, benefits are frozen, the bins aren’t emptied etc. Left unresolved and taken to its ultimate extension, as the Congressional Budget Office conceded, what it really says is that it is a choice between paying federal wages or distributing coupons to bond holders: you can do one or the other, but you can’t do both. Brutally, the government can pay its employees but the country is bust because it technically defaults on its loans and risks a systemic financial melt-down, or it keeps its creditors (i.e. its bondholders) at bay but it has riots on the streets. It’s Hobson’s Choice with knobs on.

The Debt Ceiling is a self-imposed limit, currently $31.4 trillion, a sum which was breached on January 19th. There is an emergency contingency under which the government is now operating, however it is strictly limited both financially and in terms of time. But the ceiling itself is arbitrary; that is why it is annually up for renegotiation and usually ends up being raised. It is a very different system from, say, Germany, where the ‘debt brake’ regime implemented in the wake of the Global Financial Crisis dictates that it is illegal for the government even to present a budget that involves a deficit. The German system might be inflexible (indeed that is exactly the point!) but it is clear and unambiguous, and it prevents the problem arising in the first place, though occasionally it is tested beyond its limits as last year with Olaf Scholz’s intra-year €200bn electricity price-cap policy. But without that discipline, in the US the resulting horse trading leads to endless compromise and fudge, almost invariably meaning the ceiling is pushed up. And suddenly it has a debt/GDP ratio at 130% and they wonder where it came from. It is a distinctly uncomfortable and expensive position in which to be when interest rates have gone from zero to 4.75% in less than a year and still have further to go. No doubt it will be resolved, even if it goes right to the wire; even hard-line Republicans are not so obtuse as to be responsible for a potential systemic collapse in international bond markets (as if the UK’s episode last October was not enough of a wake-up call), nor would they wish to alienate millions of public sector workers with a Presidential election now within view.

But stand back from the hum-drum day-to-day squabbling on Capitol Hill about what among public services and wider government spending might or might not be pared back; all this is window-dressing at the margin. The essential truth is that the US is not only living beyond its means, it is serially fiscally incontinent. Indeed, it has been without a break since 2000, the last time the US produced a government surplus. Reaganomics put the US finances on a sound footing and the deficit/GDP ratio reduced almost every year (the 1991/2 recession caused a small setback) from 1983 (5.7%) to 2000 (surplus of 2.3%). Since then, it has been downhill all the way and although it has bounced back from 2020 and the pandemic (14.9% deficit), the deficit is now 5.4% and back on the deteriorating trend line. Regardless of who has been in power, Democrat or Republican, that is the cumulative effect of two decades of lazy Keynesian fiscal policy (exacerbated by the government response to the pandemic), aided and abetted by a compliant central bank prosecuting a prolonged ultra-loose monetary strategy, and complicit markets. It is the type of unchallenged, consensual economics the IMF wholeheartedly approves of. Here in the UK, we have no cause to gloat: even if not at 130% geared (we are nevertheless approaching 100%), ours is a depressingly similar habit.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.  

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