Global Perspectives: Disinflation creates solid ground for rate cuts

Matthew Bullock: Hello, and welcome to the latest recording in the Global Perspectives Podcast Series. My name is Matthew Bullock, and I am the EMEA Head of Portfolio Construction and Strategy, and today we’re fortunate to be joined by Jenna Barnard, Co-Head of Global Bonds here at Janus Henderson. Great to have you here, Jenna.

Jenna, I’ve been really looking forward to this conversation because there’s such a range of topics to discuss in the world of fixed income, and it’s such a dynamic market. In particular, it feels like it’s more dynamic this year, where the market’s really just on tenterhooks, waiting for any announcement, whether it comes to interest rates or inflation.

In fact, we postponed this podcast. We were going to do it just over a week ago, but were waiting for some data when it came to inflation and labour statistics. In such a dynamic market, I want to go into some of the drivers of that, but before I do that, I want to go a little bit back in time to 2022, which I know was a terrible year for bond investors.

And 2023 was going to be the year of the bond, the recovery period, which didn’t really happen. The question that I get asked a lot when I’m talking to clients is, 2024, is this finally the year of the bond?

Jenna Barnard:  So, if we think about what happened in 2023 that meant it wasn’t the year of the bond. Broadly, the market was right on where it priced US interest rates peaking. All the way back in October 2022, we priced the US terminal rate, peak rates, this cycle would be 5% or just over, and we got to five and a quarter in July 2023. So the issue wasn’t really the market’s pricing of short-term interest rates.

What happened in 2023 was a really unusual event, which is, after you had the last rate hike, which in the US was in July 2023, I think Bank of England was August, ECB was September, but let’s take July for the US, ten-year yields surged. They surged over a hundred basis points in about two or three months. In capital terms, that means bonds dropped about 8% in that three months.

And that behaviour of bond yields actually rising aggressively, after the last rate hike, we haven’t seen in the last 40 years. If you went back to any cycle from, I don’t know, say 1984 onwards, ten-year yields just decline.

Once you have the last rate hike, the market knows that it’s done, basically. Cuts eventually happen. You can debate when. And ten-year yields fall.
And there are six cycles since 1984, and they fell in all of those examples. This phenomenon where ten-year yields surged after the last rate hike, that’s what happened from 1969 through to 1981, so very 1970s bond market behaviour.

Technically, it was something called a bear steepener, which I don’t know if it’s too much for this podcast, but two-year yields rose a bit, but ten-year yields rose even more, so the yield curve shape steepened. Again, exactly what happened in the 70s. And that’s really difficult to square with the inflation fundamentals that look completely divergent from the 1970s, and I think that’s something you want to talk about later.

Yes, it was disappointing, but not because I think the market was wrong on where interest rates were going to peak. And I keep talking about the US, because it’s just under half of the Global Aggregate Index. It’s very important. It’s just a disproportionate weighting in US dollar bonds.

It wasn’t the interest rate pricing that was completely wrong. It was the behaviour of these longer-term yields, following the pattern, something we wrote an article about last October, actually. So, I thought that’s just… You wanted to start there? Let’s start there. If we got interest rate cuts, and ten-yields rose, they didn’t fall, I’ve got nothing. I’ve got no historical case studies, going back to the mid-1960s, where that’s happened.

If we’re going to get rate cuts, which is what the market’s pricing, equities are assuming, central banks are indicating, and the inflation data supports. If we get rate cuts and ten-year yields rise, I’ve not seen anything like that, going back 60, 70 years.

And then we’ve got a whole world of problems for multiple asset classes and for just understanding what on earth is going on.

Bond markets are on, I think, pretty solid ground this year in terms of the expectation for rate cuts. You can debate when they’re going to start. Who cuts first? Who cuts the most? And if it’s not the year of the bond, then I think it gets very interesting.

Bullock: Then let’s flip to the US, then. You’ve got a message there from [Fed Chairman] Powell, that rates have peaked, but then pushing back on that expectation of immediate cuts. Is it definite that you’re going to see rate cuts around the world this year? think I would add, equity markets are quite narrow and quite thin and it has all been P/E expansion, Adam. It is not justified by current earnings growing or even the forecast of future earnings growing. I think the long and variable lags that everyone talks about in monetary policy, a lot of them haven’t hit yet because the bulk of the tightening broadly happened this time last year.

Barnard: The expectation for rate cuts, and the reason they’re priced into bond markets, is almost entirely a function of inflation or I should say disinflation dynamics.

We had this remarkable disinflation and core disinflation, not just headline, at the back end of last year, and that was a really globally synchronised surprise to the downside.

As we’re sitting here, I think if you take the US, you’ve got core PCE [Personal Consumption Expenditure], which is the core inflation measure that the Fed targets, at 2.9% year-on-year. Even with last week’s surprise, yes, six-month core PCE was at 1.9%. Now it would be low-to-mid twos.

And you’ve got base effects which mean that lagging 12-month inflation, it’s just mathematically, it’s going to be very difficult for it even to bottom here. It’s going to be dragged down because of base effects, so by May, which is when the market’s playing with a May or June rate cut in the US, you’re talking 2.4%, 2.5% core PCE.

If you hold rates at five and a quarter, the argument would be that the real interest rate, the difference between inflation and that nominal interest rate, is rising. And you’re getting back to levels of inflation that are near enough to the 2% targets.

Very different, again, from that 1970s experience that everyone seems to anchor to. Core PCE did not fall below 2.7 from 1966 through to 1992, and when it did get to 2.7%, 2.8%, it just catapulted back up.

If you’re getting core inflation down to those levels, with lagging rents in the US also likely to be weighing on core inflation over the next 12 months, that’s pretty solid ground for cuts to start, by mid-year.

And then, maybe if we turn to Europe, where actually cuts may even come a bit earlier than the Fed. There’s a debate there about whether it’s April or June. Again you’re going to get headline and core inflation coming down very fast and towards those mid-twos for core by the summer.

Bullock: Does anything worry you about reigniting inflation? Is there anything you’re looking out for?

Barnard: There’s nothing at the moment in the data. Obviously, you always worry about it, because geopolitical shocks and commodity prices and things. But actually, what’s going on under the surface is actually we’re having a lot of disinflation over commodity shocks. If you take natural gas, for example, whether it’s European LNG prices or Asian, or US natural gas, domestic prices, they just keep falling. We see that daily on our Bloomberg screen.

The oil price hasn’t risen since the October turmoil in the Middle East, and then goods prices remain pretty weak. And services, there’s obviously a debate about how slowly or fast that might get squeezed out.

But as we sit here today, I wouldn’t say there’s anything under the surface that’s a rising inflationary force, as we speak. It’s something people worry about, that a new shock may come, but that’s not what’s been going on.

Again, very different to the 1970s, where if you took the US gasoline price in the 1970s, you’d get these oil shocks, then it would just plateau. It would just plateau, and then you’d get another shock and it would rise. You wouldn’t have these big retracements back down, that we see in the likes of natural gas and even oil prices.

Bullock: If I look at the actions of central banks when they increased rates, there was an accusation they moved too late and too slowly. The reverse of that could be true this time round, which is, the banks are too slow to cut rates. Do you think that’s a risk?

Barnard: It’s a revealed preference of central banks. I think they say this quite explicitly, that there’s always a risk that if they don’t squeeze out inflation, it’s the 1970s all over again. And they’d rather be too late than too early on rate cuts.

Bullock: Based off that then, if they are going to be too late on the rate cuts, and we saw the UK go into recession, and I’ll just stick to the UK for the moment, is the risk then that the market is not correctly pricing in a recession? And actually, we could end up in a deeper recession than anticipated?

Barnard: Yes, I think that’s always a risk given the lags of monetary policy. Andy Haldane, who was the chief economist at the Bank of England, is I think quite explicitly warning about this in the last week or so, that actually to get some insurance cuts in now is a good thing. Just to stave off that risk to growth, because you’re never going to get the timing quite perfect.

But I think the last two years, it’s clear that central banks would rather risk growth than sticky inflation. Obviously, this is a debate for outside the US, because within the US, you’ve got a much stronger GDP dynamic going on.

But in geographies like Europe or the UK, where growth has really been stagnant for two years now, mild, technical recessions here and there, but just really lacklustre, yes, I think it’s still inflation at the forefront of the central bank’s mind. I think the longer they leave it, the bigger the risk of larger cuts eventually coming, but they’d rather be late than early. I think historically as well, the Federal Reserve’s tend to led, lead rather, rate cutting and rate hiking cycles. That might not be the case this time. I think I mentioned the ECB possibly might sneak a cut in, a month earlier. We’ll see what happens. But it has historically tended to be the case that the US would lead, and other central banks would follow.

Bullock: I think credit spreads have moved all over the place with what was going on in the rates markets.

But yes, defaults have been extremely low, and I would say no huge surprises in terms of the sectors that have got in trouble, so there’s not been really a new narrative to drive credit markets.

I think the problem sitting here today for credit is, you could get very bullish on credit, if you looked at it on a yield basis. And that’s largely because the government bond yields are still so high, and then you get a spread on top, for the credit risk.

But from an all-in yield perspective, these are still some of the highest yields we’ve seen in 15 years, so from a yield perspective, there’s a lot of hungry yield buyers out there.

That could be insurance companies who are selling annuities. It could be retail investors, who are just attracted by the all-in yield.

But then, if you looked at credit just on that spread element, so just the extra yield you get to compensate for the credit risk, you could get very bearish. It’s pretty much pricing in that defaults are going to stay at 1%, 2%, just historically low levels, so you take your pick, really.

At the moment, credit’s being driven by the yield buyers. There seems to be just incredible demand to lock in those yields, particularly in investment grade, which is more of a core fixed-income product, so few defaults, higher quality, but longer dated, longer duration.

There’s been a huge surge in supply, year-to-date, both in Europe and in the US, but the demand has more than outstripped that.want to briefly touch on credit. In the world of credit, the word resilience has been used quite a lot, as far as there’ve been obviously the rapid rate increases that we’ve talked about. But then, corporates have generally held up okay, and we haven’t seen the defaults that we probably would’ve expected going back 12, 18 months ago, when we started to see the rate rises coming through.

Bullock: Do you see defaults picking up materially?

Barnard: Not materially, no. You had little mini peaks in defaults, particularly in the loan market, which is a floating-rate asset class, so interest rates for those companies did go up a lot, with interest rates. But I wouldn’t say there’s a new default story out there as we speak.

Bullock: What about sectors, does that make a difference?

Barnard: Sectors? Yes, it does for us, because we don’t run money against an index, so we can avoid problematic sectors. It has been more of a sector story, I would say, in the last couple of years.

Even if you go back to 2014, 15, we had the shale gas defaults in the US. That drove US high-yield default rates up to mid-single digit. Then we washed out some of the weaker zombie companies post-COVID, and then since then, it’s sectors like communications in the US, and real estate in Europe has been problematic.

Yes, for us, running money not against an index, it’s quite easy to avoid problem sectors and problem credit, because often they’ll be zombies for a while before they actually default.

Bullock: Yes, because I’m just thinking there are lots of headlines I see in the paper, more to do with… Property is an obvious one. But also, banks in the US, or small, mid-size banks, and pressure building up on those.

Barnard: Yes

Bullock: Whether there’s some impact that could have a much broader impact, a contagion impact on the market?

Barnard: No. I think it would have if it was pre-2008, but that regional banking crisis last March, when it exploded, the Fed just came in and offered liquidity to the banks, completely separate from the interest rate policy.

And then actually this year, there have been problems in the German banking sector, related to commercial real estate, but again quite idiosyncratic and small, so no, it doesn’t seem to have had the systemic contagion effects that you would expect and that we saw in prior cycles.

Arguably, it’s had an impact on lending, ability to lend, willingness to lend, but not in the systemic risks that credit spreads are often so sensitive to, and they drive credit spreads at certain times.

Bullock: Just to finish off, one of the things I wanted to touch on is, you mentioned briefly, I think in your first response you mentioned geopolitics.

You can go into politics, if you wish, in the discussion, but I’m not going to ask you so much about your views on any of these things.

But if we look at this year, where it’s slated as the biggest year for elections, as far as the majority of the world population going to the polls, you’ve also got the instability surrounding the war in Ukraine, you’ve got instability in Gaza.

Now, there’s lots of unknown things that could occur over the course of the year, and what I’m really interested in is, how, from a portfolio perspective, do you think about these things? How do you protect a portfolio against so many different things that could happen in such an unstable environment?

Barnard: It’s just really difficult, because the dominant factor driving the bond market is going to be cyclical dynamics, inflation, growth. We had instability and we have had instability in the Middle East since October, and the oil price has fallen. The natural gas price has collapsed, over 30%.

As a portfolio manager, I’m sitting there, looking at the things I can understand and which drive the performance of the asset class. They are cyclical. We have unpredictable headlines, and we can speculate on what they may be, but even if they do hit, they can drive commodity prices in a way that you wouldn’t expect.

And oftentimes, they may be expressed through curve shape, rather than necessarily aggregate bond yields as well. I won’t go into that detail in this podcast.

I would say that all of your questions have been predicated on inflation shocks, and we have a major disinflation shock going on from China. I’ve talked about commodities and actually how disinflationary they are under the surface. I think what’s really interesting actually is that I come into a bond podcast like this, and I have questions about all these potential inflation shocks, it’s the 1970s all over again.

There’s this massive anchoring to the 1970s, and I see it from central banks as well. The last mile is the hardest.

That IMF paper from last September used data from 1973. Look at the 1940s. You have inflation shocks that then just collapse, because commodity prices collapse, or the supply comes back.

There are many different inflation paradigms that we can look back to, but we’re fighting this complete 1970s obsession that central bankers don’t want to be [former Fed Chairman] Arthur Burns, and that the Middle East is all like the 1970s.

Go and have a look at the US gasoline price in the 70s. It didn’t come back down. It just went up, plateaued. Went up, plateaued. It’s tricky. I know the burden of proof is from the bond bulls, no one believes the disinflation, but the surprise could be this year, that core inflation just comes back down to the mid-twos, low-twos, as it’s priced by the bond market, and we get rate cuts.

Rates don’t stay at five and a half forever, and actually the bond market’s pricing in that rates come down to 3.5% to 4% in the US, UK, over the next two years. That’s not particularly aggressive, so yes, let’s have a podcast about all the risks to the downside, because I can talk about that.

Bullock: We’ll definitely do that next time.

Barnard: We’ll see. I can understand why that anchoring goes on.

I think that probably the biggest worry would be the US election actually, for bond investors, and the fiscal dynamics. That would be the new one, in terms of…

Bullock: We should do another podcast closer to the time, then.

Barnard: Yes, I’m not sure I’d be that helpful. You might want to do it with the US portfolio managers. But yes, it’s going to be a global event.

And as I said, 45% of the Global Agg Index is US dollar bonds, but again, I think everyone’s predicated to think of constant fiscal expansion as their base case. It’ll be interesting to see how that pans out this year. But as we sit here today, two, three years after these major inflation shocks, it’s panning out much better than most bond investors could’ve hoped for, if we’re looking at core inflation.

We’re really starting to diverge from that sticky inflation narrative, the last mile’s the hardest narrative, which was all anchored to the 70s. We’ve got a bit more work to do.

It’s still too high from a level’s perspective on core inflation, even in the US, which has led the disinflation, because they didn’t have the natural gas shock we had in Europe.

But potentially, we’re a few months away from a very interesting time for bond markets.

Bullock: Considering the time, I think we’ll finish it there. But I want to firstly thank you, Jenna, so much, for all of your time. It’s been fascinating. And very importantly, to thank the audience as well for listening.

And of course, if any of our listeners wish to learn more about Janus Henderson’s investment views, or if you have any other questions, then please don’t hesitate to contact your client relationship manager or visit our website. With that, I thank you all very much for listening, and I wish you a very pleasant rest of the days.