Financial Update from Brewin Dolphin - 10 November 2023
The Weekly Round-up
Friday 10 November 2023
In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses the impact of potentially lower interest rates on the markets and bond yield decline in Japan.
Last week saw a strong rally in the bond market. This week, bonds have remained reasonably well bid but the picture is certainly more nuanced. The all-important Treasury market saw some curve flattening (shorter-term yields rose, while longer-term bonds were little changed).
Federal Reserve chairman Jay Powell’s comments reiterated this week that he doesn’t want investors assuming that interest rates are about to be cut. At this stage in the interest rate cycle language becomes important and heavy with subtext. Just a few weeks ago, Fed speakers were able to point at the rise in bond yields as a factor that contributed to a tightening of financial conditions (the same could be said of the volatility in equity markets). Such a tightening weakened the case for further interest rate increases. With the US having recorded a weakening trend of jobs growth during 2023 and evidence of slowing economic momentum from the Institute of Supply Management’s purchasing managers indices, the probability of further interest rate increases declined, and bond yields fell accordingly. So, the whole process has gone into reverse, with Fed members like Powell keen to prevent conditions loosening too much, and therefore emphasising that rates are not about to fall and could even rise.
There has been a bit of ebb and flow in central banker tone in the UK too. Huw Pill, the Bank of England’s Chief Economist, gave a speech in which he emphasised that policy had tightened considerably but would need to stay tight. He suggested that this could be until at least the middle of next year. This was taken as an indication that rates could be cut shortly thereafter. Governor Andrew Bailey’s comments the following day struck a more hawkish tone. But over the span of the week, our preference for UK bonds has continued to be rewarded.
As a reminder, the UK is more interest rate sensitive than the US, but up until this year it was perceived that the US was more likely to cut interest rates sooner than the UK.
Over recent weeks, the interest rate outlook has become more aligned in both countries.
A question of risk and reward
As we are discussing interest rates, it is sensible to address a popular question at the moment. Is it worth being invested when relatively high rates of interest can be achieved in bank or savings accounts? The answer is that whilst everyone should make sure they have secure liquid assets to call upon for the immediate term, over time, invested markets have historically rewarded the extra risk which is taken.
Just a data-driven hint that lower interest rates could be on the way last week was enough to cause a sharp rally in equity and bond markets at the end of the week. We do our best to time movements between asset classes, but above all, it makes sense to have an appropriate portion of wealth in invested assets to achieve higher expected rates of return – this to protect wealth against inflation and to reduce the degradation of returns that comes when interest rates fall.
We can see the combined interest rate expectation of market participants reflected in derivatives prices. According to the markets, rates are expected to remain flat for the next three months and then start to decline, accelerating thereafter. In fact, the UK yield curve has steepened a little (implying interest rates which are low and on the rise) while the US curve has flattened (reflecting interest rates which don’t fall quite as much as had previously been expected).
GDP surprisingly strong in third quarter
Also announced this week was a first estimate of GDP for the third quarter. It was surprisingly strong if 0% can ever be described as strong! The economy had been expected to contract. We have discussed the reasons in previous weeks. The nicer weather in September delayed a lot of autumn wardrobe shopping. But this was partially offset by changes in inventories and net trade, which tend to be volatile and hard to predict.
Japan relaxes yield curve policy
Another market which has seen its longer dated bond yields decline is Japan. It is over a week since Japan changed its yield curve control policy in ways which have been interpreted differently by different people. To us it seems like a huge relaxation of the policy, to the point that it barely exists anymore. Theoretically, the Bank of Japan (BoJ) has continued to maintain a policy of keeping the ten-year Japanese Government Bond yield around 0% but the symmetrical band within which the yield would be maintained has been abolished. The BoJ is now only monitoring the upper boundary. And while in its previous iteration 0.5% was a reference rate for the currency and 1% was a hard limit, now that 1% has become the reference rate and there is no hard limit. Given the ease with which yields flowed through the previous reference rate, investors can have little confidence that the Bank of Japan will defend that 1% limit. And so far, it appears that this gambit has worked. The BoJ is spending far less in the bond market and yet yields have actually been falling. Evidence suggests that the Japanese economy is slowing anyway, and so the upward pressure on yields seems to have moderated.
What has not eased has been the pressure on the yen, but this reflects the fact that short-term interest rates have been anchored by the more effective part of Japanese monetary policy, the mildly negative short-term interest rate. Although there has been a bit of ebb and flow around the outlook for US rates, the only modest increases in Japanese rates seem very meagre by comparison.
Reflecting the recovery in bonds yields has been a recovery in growth style factor over the past fortnight. The move has been broad, encompassing most major regions (including Japan). It seems like a good time to pare back gains from value focused Japanese strategies.
The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.
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