Pamplona in the bond market as it anticipates aggressive central bank policy rate reductions

From

Stephen Miller

Running with the bulls can be exhilarating and, in an investment sense, frequently rewarding. The rally in bond markets from late October into year-end provided that exhilaration and reward for that cohort of bond investors fortunate or perceptive enough to capture it.

Bond investors ended 2023 in full Pamplona mode as bullish sentiment spurred by an expectation of aggressive Fed policy rate cuts pervaded bond markets. That saw the US 10-year bond yield lurch below 4 per cent for the first time since July 2023 while the 2-year broached 4.25 per cent for the first time since May 2023.

Some went as far as to posit “equity-like” returns from bond markets in 2024.

To some extent that optimism is supported by a marked improvement in the Federal Reserve’s (Fed) favoured measure of inflation – the core private consumption expenditure (PCE) deflator. That measure stood at 3.2 per cent in November, the lowest since March 2021, before the Fed commenced its current (aggressive) tightening cycle. Looking at the “pulse” measure (3-month annualised rate of change), inflation in November stood at 2.2 per cent, close to the (informal) Fed target of 2 per cent.

However, what is eminently questionable is the extent of policy rate reduction priced. Earlier in the year markets had posited well in excess of 150 basis points of policy rate reduction. That has been pared a little following some push-back from various Fed spokespeople, but markets are still pricing anywhere between six and seven 25 basis point policy rate reductions this year.

The median Fed’s “dot plot” issued on 13 December is implying something closer to 75 basis points of policy rate reduction for 2024.

To be clear, the Fed’s forecasts of its own policy rate actions are frequently inaccurate.

However, at this juncture, I am more persuaded to the Fed view rather than that reflected in the market.

Rather than “immaculate” and smooth, the process of disinflation tends to be more disjointed: a process of “two steps forward and one step back” with the “last mile” to the inflation target proving particularly challenging, particularly in an environment where economic activity is resilient.

There are key structural elements at work that will make that “last mile” even more daunting. The globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating; globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of “industrial policy” and “national champions”; domestic regulation of goods and labour markets is increasing in scope (leading to upward price pressures); and baby boomer workforce participation is declining (limiting labour supply and lifting wages).

The recent December consumer price index (CPI) prints in the US, Canada and the UK have upset any emergent narrative that the process of disinflation will be smooth as measures of core inflation exceeded expectations.

Inflation developments aside, the “neutral” interest rate appears to have risen from the abnormally low levels that applied post-Financial Crisis through to the end of the pandemic.

Certainly, the resilience of activity and the labour market during the recent Fed tightening cycle is suggestive of the notion that the “natural” real growth rate has increased from that in the preceding 15 years or so, and that, accordingly, the “neutral” real interest rate should also have increased.

Other observers point to other emergent secular trends that might have pushed (and continue to push) the “neutral” real interest rate upwards: larger US budget deficits; investment demands on the savings pool from clean energy investments; and boomer retirees de-accumulating savings.

An alternate view, where the bond market might be correct in terms of its expectation of aggressive rate cuts is if a recession were to eventuate. For example, last year’s unexpected resilience might have been the result of a US fiscal “sugar hit” as the budget deficit approached 7 per cent of gross domestic product (GDP), even as the economy hovered around full employment. It is difficult to see any discretionary growth in the budget deficit in 2024, meaning an almost certain withdrawal of that fiscal support – or “sugar hit”. Should that result in a hit to activity growth and the economy slows more sharply than expected, the ongoing impact of the monetary tightening in 2022 and 2023 might need to be withdrawn resulting in aggressive policy rate cuts.

The latter circumstance might result in equity type returns from bond markets and while that is not implausible, it is located at one end of the risk continuum of potential outcomes for 2024.

What about Australia and the RBA?

Australia has not been immune to the predilection of markets to anticipate policy rate reductions, albeit not of the same order of magnitude that exists with respect to the US Federal Reserve.

That is understandable given that the policy rate in the US is higher and US inflation is lower.

Nevertheless, inflation developments in Australia provide grounds for cautious optimism that the process of policy rate increases has come to an end.

It is difficult at this stage to forecast a December quarter CPI outcome for Australia that will result in a rate of (trimmed-mean) inflation that will be greater than the Reserve Bank of Australia (RBA) forecast of 4.5 per cent for 2023. Indeed, the balance of probabilities is that it will be less than that.

Today’s release of December labour force data only reinforces the case for the RBA to “sit pat” at the February meeting, bearing in mind that the unemployment rate is now part of the RBA’s remit.

Employment fell sharply, although that follows two very strong months of employment growth and there are some questions around temporary impacts from the Queensland floods. The unemployment rate was unchanged at 3.9 per cent and is broadly consistent with the RBA forecasts issued in November.

With the unemployment rate still arguably below the to the “natural” unemployment rate or non-accelerating inflation rate of unemployment (NAIRU) the labour market is still some distance from a point where the RBA would need to act to prevent an undue softening in the labour market.

Nevertheless, there is some prospect of a meaningful softening in the labour market, and along with a benign December quarter CPI that means the cyclical tightening process is in indefinite abeyance.

However, in my view there is still some distance to travel before arriving at any imperative for a policy rate reduction.

In articulating that view, I am mindful of the lessons from the 1970s is that any prevarication on the part of a central bank in articulating a consistent, coherent, and firm response to any inflation threat only heightens the risks down of a more damaging macroeconomic dislocation in terms of activity and employment down the track.

I referred above to global structural developments that might mean “stickier” inflation and the attendant difficulties attaching to the “last mile” in central banks returning inflation to target.

In her Statement following the 5 December RBA Board meeting which kept the policy rate unchanged at 4.35 per cent, RBA Governor Michele Bullock noted that “wages growth…remains consistent with the inflation target, provided productivity growth picks up.” (My emphasis)

That is a critical assumption. And despite some signs of a recovery in productivity in the September quarter, the assumed ongoing pick-up in productivity growth remains a critical assumption.

With annual unit labour cost growth (the most relevant labour cost gauge for inflation) at 6.4 per cent, it remains difficult to project any abatement of the “stickiness” in inflation for 2024 beyond that projected by the RBA unless the economy slips into (near) recession.

It is also clear that after an extended period where the RBA tolerance for an elongated return of inflation to target has been much greater than other developed country central banks, that tolerance well is now pretty dry.

The productivity challenge is given some poignancy by recent changes in the regulatory environment in Australia, particularly in relation to the wage-setting and the industrial relations framework. These changes potentially exacerbate an already stubborn inflation problem. For one thing they are broadly inimical to productivity growth and for another they weaken the link between productivity and nominal and real wage growth. Such measures run the risk of entrenching higher inflation in Australia compared to elsewhere particular.

The interplay between productivity and wage growth – along with movements in the unemployment rate – are therefore domestic developments upon which the RBA will cast a keen eye.

At this point the hurdle for policy reductions in 2024, while not insurmountable, remains daunting.

By Stephen Miller, investment strategist 

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