US data blurs the picture for bond investors


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Topsy-turvy US economic data released this week left markets in a pickle, but still just outside the danger zone. 

Official figures revealed on Thursday that the US economy was not necessarily streaking ahead of the rest of the developed world as thought. It turns out that growth was running at an annualised pace of 1.6 per cent in the first quarter — far behind the 3.4 per cent clip in the fourth quarter of last year and a big miss from the 2.5 per cent that economists had been expecting.

For a tiny moment, benchmark government bonds popped higher in price in response — a typical reaction to a nasty shock on growth. 

But other data blurred the picture, in particular on inflation. On Friday, the Federal Reserve’s go-to measure of price fluctuations — personal consumption expenditures figures — showed a small increase to 2.7 per cent in the year to March, a nose above forecasts and above the previous month’s reading. 

For months, holdouts hoping that the Fed will cut interest rates aggressively, and soon, have derived comfort from relatively becalmed PCE inflation data, and sought to dismiss bracingly strong readings from other measures. Figures such as Friday’s really underline that the direction of travel is not pointing that way. “Which ever way you crunch the numbers, this clearly isn’t the sort of inflation momentum where the Fed could be comfortable cutting rates,” noted Jim Reid at Deutsche Bank.

The result is that bond prices have slid back again, and benchmark 10-year bond yields are right back up to where we were in November, a little under 4.7 per cent, as if the whole frenzy around expected rate cuts in late 2023 and at the start of this year was all a weird dream. Let us never speak of it again.

The big winners here are the macro hedge funds that have placed their bets on few if any rate cuts from the Fed this year and a related sweep higher in bond yields. I’m sure we’re all delighted to see the downtrodden billionaires enjoy a stroke of luck.

For the rest of us, humble mere mortals, this combination of slower growth and nagging inflation is an unsettling mix. 

Bond markets have already taken the death of the rate-cut trade badly. “Fixed income has not gotten the joke,” said Michael Kelly, global head of multi-asset at PineBridge Investments. “It’s an earthquake.”

Stocks, meanwhile, can take this in their stride as long as higher interest rates are the result of a stronger economy, he said, and as long as investors are sure the next move in rates, whenever it comes, is a cut. “I really don’t think the stock market falls out of bed as long as the prognosis is down, not up,” he said. 

But it is that little bit harder to be certain on either of those fronts in light of the latest data, hence a bracing pullback in stocks on Thursday that was rescued only by upbeat results from Alphabet and Microsoft.

A rise in US interest rates this year remains a long shot. But it is still a prospect that some investors are starting to take more seriously. To put it mildly, “that really would be a problem for the equity market”, said Robert Alster, chief investment officer at Close Brothers Asset Management.

Right now, the market mood is somewhat downbeat, especially as the clingy nature of inflation has caught even canny economists off guard. But unlike last autumn, when the notion that rates would be higher for longer last really set in, it is calm. Some investors are even relishing the chance to load up on more stocks after a rare recent dip in prices. The key to what might make that change is the number five.

Round numbers should not matter in markets, but the reality is that they do, and the closer the benchmark 10-year Treasury bond yield rises towards 5 per cent, the louder the noise will become.

If you cast your mind back to October, approaching and then hitting that point unleashed a moment of panic around the really big questions. Who will buy all the US government bonds? How will the world’s pre-eminent superpower fund itself? Will the dollar remain the key global reserve currency?

As ever, the answers to those questions were — 1: everyone, just at a lower price; 2: see 1; and 3: yes. But it is never a comfortable experience when those are the debates.

The current reset in bond yields is different from last year’s. Inflation, while higher than desired, is markedly lower. But when yields hit those sorts of notable highs, the question around whether it is really worth buying stocks when you can bake in those returns on risk-free bonds becomes sharper. At the same time, the gold bugs and fiscal crisis enthusiasts come out of the woodwork, putting a cap on broader enthusiasm for risky assets.

Investing is never as simple as “big number, sell everything”. But when the mood is jittery, these mind games can have a real impact.

“Five is a really good number,” said Alster at Close Brothers. “As long as we’re under five and the inflationary data is not deteriorating . . . we can convince ourselves that the next move is down, and I think we’re going to be OK.”

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