Fixed income markets fluctuate between climbing a wall of worry and wanting to be off to the races. With a new conflict in the Middle East and the US government in deep financial trouble again, less than a fortnight ago, seeing only treacherous economic reefs and shoals as an onshore wind blew the ship towards the rocks, investors had pushed the yield on the US 10-Year Treasury to over 5%, the highest since before the Global Financial Crisis. Last week, a swift about-turn and today, nearly half a point lower, it stands at 4.6%. Other sovereign yields have retreated too (and prices have moved in the opposite direction).

 

Not for the first time in this volatile interest rate cycle, the markets have decided to ring the bell: to lock in a positive real yield (where the effective rate of interest is above the rate of inflation), and to make an assessment that the upside in future bond prices is probably greater than the downside. Feeding this perception directly was the similar and simultaneous narrative from the US Federal Reserve, the European Central Bank and the Bank of England that interest rates have probably peaked (note the qualifier, ‘probably’; the Federal Reserve in particular has not ruled out further rises in rates). Where opinions vary is what happens after.

 

Spot-the-Dot: playing ‘guess the interest rate’

All three central banks remain resolute: that although inflation is in retreat, it is not a foregone conclusion that it is beaten into submission. The ‘higher-for-longer’ theme for interest rates still holds, particularly because of the innate lag between a policy change and a measurable impact on the economy of around 18 months to two years.

This week, the Bank of England’s chief economist, Huw Pill, commented that there could be a case for UK base rates to see one cut before the next election, which assuming by a quarter point would still leave the Base Rate at 5% at the end of 2024. Pill is not making a forecast, merely flying yet another kite and offering his opinion.

In the US, members of the Fed’s monetary policy committee as far back as September were individually estimating that US Fed Funds rates would ease in 2024, ranging in expectations from 4.3% up to 5.5% (the current Fed Funds rate is 5.5%) but with half the participants pitching their guess below 5% and a median estimate of 5.0-5.2%; the resulting graph of their individual estimates is known in the markets as the “dot plot”. Interestingly, to the extent that central bankers are any more or less accurate in their forecasting than anybody else (the old joke: weather forecasters were invented to make economic forecasters look good, ha! ha! ha!), in the most recent US Summary of Economic Projections in September, not one of the Fed forecasters saw a nominal rate of interest below 2.2% for the foreseeable future (we analysed why in an earlier Merlin Macro column on 14 April 2023, “What the IMF Doesn’t Know”). The SEP’s annual time series extends to 2026, after which the remaining ‘dots’ are simply described as “longer run”.

Essentially therefore, the official expectation is that over the next three years, US interest rates will halve from where they are today, but among those who set policy, there is no anticipation of rates going aggressively lower than that.  Investors on their part have ‘priced in’ an expectation of a three-quarter point cut by the end of next year to 4.75%. In a keynote speech this week, Fed Chairman Jay Powell warned against the reliability of the current published SEP “dot plot”, particularly the near-term projections; as it is and knowing that Fed forecasters are as fallible as any other, experienced investors apply such forward looking data as contextual evidence, not hard science: it has been wrong before, and will be again.

While some investors anticipated the interest rate cycle would resemble an inverted ‘V’ in which rates reached a peak and then immediately reversed with the same alacrity with which they were raised, that hope has already been demonstrably frustrated.

Much is about momentum and sentiment. It being impossible to make money from prices which do not move, markets are determinedly using every shred of evidence that economic growth is weakening to lead the central banks by the nose: to get them to start relaxing interest rates earlier and faster than the natural caution of central banks dictates. The markets are in a hurry to recover the punitive losses in fixed income incurred over the past couple of years: as a painful reminder, moving in the opposite direction to the yield, in 2022 in the government bond sector the price of the UK 15-Year Gilt slumped 40.2% and so far this year has conceded another 8.6%; in dollar terms, the US 20-Year Treasury fell 22.8% last year and has declined 11.3% year-to-date. The central banks, stung by the justifiable accusations that they were asleep at the wheel when inflation was showing signs of running amok in mid-2021, are determined to reassert their authority and repair the damage to their reputations, keen to impress upon us that they do, in fact, have a rough idea what they are doing. But even within the central banks, diametrically opposing opinions are never far below the surface as to whether enough has been done already and any further tightening of monetary conditions risks significant economic damage, or whether stronger medicine is still needed to ensure inflation is beaten out of the system.

Horses for courses

The most recent economic data suggests that at last, there is evidence that the most aggressive rate-tightening programme in modern economic history is beginning to produce results, helping towards the aim not only of achieving 2% inflation, but also maintaining reasonable price stability thereafter. However, the picture is not uniform.

In the UK, the economy is stagnant on a quarter-on-quarter basis, literally so in the June-September period, and has been for 18 months. Retail sales are weak. Unemployment has been steadily rising for over a year from a low of 3.5% to 4.3% today. However, worryingly for the Governor of the Bank of England, wage inflation remains above 8%, exceeding the rate of economic inflation of 6.7%. With an admission by Andrew Bailey that the Bank’s success at economic forecasting has been consistently wrong, particularly calling inflation, make what you will of his recent assessment that he sees no material growth in the UK economy this side of 2025.

The eurozone economy stuttered in the third quarter of 2023, shrinking by 0.1% against the previous quarter; on a year-on-year basis, 0.1% growth was as good as it got. In Germany, the Composite Purchasing Managers’ Index for goods and services declined to 45.9 in October having been consistently below 50 since July (PMIs are not hard, reported data; instead, they are a barometer of an intangible: sentiment derived from monthly polls of business leaders as to future trends for orders, prices, wages, other input costs, etc; when compiled into an index a value above 50 implies confidence and economic growth, the bright sunlit uplands; below 50 and everything is tending towards contraction, Eeyore’s gloomy place, all boggy and sad). Despite the volatility in fuel prices, against this backdrop it is not surprising that German inflation fell from 4.5% in September to 3.8% in October.

If the eurozone and the UK are stagnating, the same cannot be said for the United States. Humming along at a year-on-year growth rate of 2.9% in the third quarter, it showed four consecutive quarters of accelerating GDP. Defying the script, growth in the third quarter over the second quarter was a whopping 4.9%. No wonder Fed Chairman Jay Powell is in no hurry to encourage markets that interest rates are likely to ease in the near future. However, there are glimmers of underlying weakness. Unemployment crept up to 3.9%, still a very tight labour market but nevertheless the highest jobless rate seen since the beginning of 2022. Caught between conflicting mandates of managing both inflation to a target of 2% and maintaining full employment, Powell has conceded before that in order to weaken the wage component of inflation, a pre-requisite is loosening the labour market (i.e. of necessity causing people to lose their jobs). Consumer confidence, though still strong overall, has been on a weakening trend; as for the PMI’s, at 50.0 and 50.6 respectively, the manufacturing and services sectors are flirting with a slowing outlook. Perhaps the Fed will yet manage the ‘soft economic landing’ it has been trying to engineer.

However, the US government still remains in special measures having busted its debt ceiling for the second time this year; a guillotine is reached on November 17th beyond which time if Congress has still not reached a substantive agreement with the government about public service funding, then either the public sector will close down, or the US will default on its debt. As the clock runs down, Congress is staggering on its way there but it remains to be seen whether any agreement is merely another sticking plaster on an aggressive tumour, or there is real commitment towards radical surgery for public sector reform. But as a recognition that the situation is serious, and the US authorities need to demonstrate some semblance of fiscal prudence, the Fed reassured investors that what was potentially a deluge of debt being refinanced by the Treasury with long duration bonds would instead be met by a smaller quantity of short-term treasury bills. Markets took some solace from that technical rearrangement of the monetary deckchairs (and as a very deliberate warning shot across the Fed’s bows, in a disastrous auction of 30-Year US government bonds this week, a quarter of the issue was left behind, the worst auction result for three years; a sure sign that investors are underwhelmed by the longer-term US economic prospects, particularly if the Federal Reserve is not standing behind them as the guaranteed buyer of those bonds to alleviate investors’ risk, as was the case during Quantitative Easing).

The Goldilocks Summary

In a complex and volatile environment, we hope this summary of the economic situation gives some clarity. Put simply, while governments are still largely in denial about their own culpabilities for helping stoke inflationary pressures, the central banks with only blunt instruments to hand, are attempting to inflict just sufficient economic pain that it re-bottles inflation but without killing the economy stone dead with a deep recession. But the result is a bit like Goldilocks and the Three Bears: whether the porridge is too hot, too cold or just right is something you only discover when you’ve already tasted it. On which deeply philosophical note…

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.

Authors

The value of active minds – independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

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The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.

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This document is for informational purposes only and is not investment advice. We recommend you discuss any investment decisions with a financial adviser, particularly if you are unsure whether an investment is suitable. Jupiter is unable to provide investment advice. Past performance is no guide to the future. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested.  The views expressed are those of the authors at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change.  This is particularly true during periods of rapidly changing market circumstances. For definitions please see the glossary at jupiteram.com. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given. Company examples are for illustrative purposes only and not a recommendation to buy or sell. Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ are authorised and regulated by the Financial Conduct Authority. No part of this document may be reproduced in any manner without the prior permission of JUTM or JAM.