Macro
The US labour market remains very strong, with this week’s payroll report reflecting 303,000 jobs added in March (vs 214k estimated), with the unemployment rate and average hourly earnings (MoM) as expected at 3.8% and 0.3%, respectively. Such a report suggested that the economy is still booming and that in this economic environment, the neutral rate of interest is much higher than it used to be in the recent past. The natural rate is higher due to a few reasons:
- Economic growth is above its long-run potential despite high-interest rates.
- Job growth is above the natural growth of the labour force despite the large immigration.
- Loose financial conditions due to extraordinary levels of fiscal spending reflected in tight credit spreads and equity pricing
- The market estimate of the natural rate (4% based on the long-term forward rate) is higher than the FED estimate (2.6%),
- Large budget deficit and large planned investment, which puts upward pressure on yields
Growth expectations have increased with pickup in the cyclical part of the economy. Post-Covid, consumers have found a heightened propensity to spend, way above the historical average. The average post-covid saving rate is only 4%, and the current saving rate is just 3.7%. In comparison, the long-term average spending rate was 6% before Covid. This leads to a higher consumption rate and stimulates the economy. We also have continuous fiscal stimulus with current government spending of about 22% of the nominal GDP ($6.5 to $7 trillion). As long as the government keeps spending money at the current pace, the US should avoid a hard or even soft landing.
CPI swap contracts have been very reliable indicators of inflation in the last few months. Current valuaiton points to CPI MoM of 0.3% and CPI YoY 3.4% (3.2% prior) with CPI Ex Food and Energy YoY of 3.7% (3.8% prior). One reason for the headline CPI to increase in March was the 6.8% increase in gasoline prices.
High growth and a strong labour market usually push inflation expectations, but they can coexist with normal inflation. The decision on cutting in June and July will strongly depend on next week’s March CPI report, and this week’s strong employment numbers will have a much less impact on the FED’s decision.
Rates
So far, 2024 has not been good for bond bulls, with losses mostly driven by duration exposure. Investors positioning their portfolios for slowing global growth and easing inflation pressures significantly underperformed as global bond yields rebounded and growth continued to be robust. The Treasury market remains volatile, with a 3% loss for the month of April.
The market started to absorb that the FED does not need to rush to cut rates. The hot payroll report sent 2Y yields 8 bps higher on Friday, which was 4.70%. The path of rate cuts has been meaningfully pushed forward from the summer to the fall of 2024. The odds of June and July cuts have fallen meaningfully, while odds point that the start of the rate cuts will occur in September. At the end of last year, we had 6 rate cust prices in, while now the market is only pricing 2 cuts this year.
US real yields are close to the top of the cycle, creating a very attractive opportunity. Those attractive real yields incentivise institutional investors to tap into duration trade despite obvious risks that rates are likely to rise further. For individual investors, the recent rate increase creates an opportunity to leave cash and lock in those rates for longer; however, based on the recent trajectory, they will likely find a better entry point in the coming weeks.
We can look at the MOVE Index to set bond market participants’ expectations on future interest rate volatility. MOVE is the average implied volatility of the selected call and put options on US treasury bonds with a one-month expiration time. The Move Index level is high, reflecting uncertainty about the narrative of where we are going with rates.
Lower bond auctions can become a negative signal for bonds. We see that the bid-to-cover ratio has dropped (it was 2.5, 2.34, and 2.37 times for 3Y, 10Y, and 30Y maturity, respectively, compared to the March ratio of 2.6, 2.51, and 2.47 times for 3Y, 10Y, and 30Y maturity, respectively).
Credit
Credit spreads are at the multi-year tights, approaching the historic bottom decile. However, the dispersion between different bond qualities is growing. Spreads now look too tight relative to the risks of future economic weakness.
For the IG corporate credit, the US market looks the least attractive of all DM markets on a risk-adjusted basis. Spreads on investment-grade bonds have tightened to historic lows, a level last seen in 2007. Europe and the UK look relatively better, but as US credit investors move capital overseas, the regional gap in the spread is converging.
As volumes at the start of the year were very high, half of the maturities for refinancing this year have already been refinanced.
Equities
Equities kept momentum and finished Q1 as Q2 with double-digit gains, helping to keep investors bullish. According to an AAII survey, investors’ bullishness remains close to its peak in March. Analysts are also bullish, with almost 80% of the market Analysts reporting a positive outlook for equities, according to a Consensus Inc. survey.
Allocation is also bullish. The BofA Fund Manager survey shows the highest level of allocations to US equities since November 2021 (however, this level is not unusual in the bull market). Furthermore, a small speculative position in the stock index future has reached the most net bullish position on record.
Also, the volatility market reflects bullishness. The put-call ratio, or the cost of call options (the right to buy the index in the future at today’s price) relative to put options (the right to sell), just came off its five-year high.
All this bullishness and AI optimism push valuations of tech stocks to new highs and increase the risk of a short-term pullback. US tech stocks multiples (PE10, PB, PDiv, EV/EBITDA, PCF) have now surpassed their 2021 heights (not seen since dot.com burst) and highs relative to the rest of the index. Heightened valuations, and squeezed risk premium for both US and Global markets to 2.7% and 3.7%, respectively (calculated as 12-month forward earnings yield minus the 10-year real rate).
As the share of households invested in stock has risen to an all-time high, the continued bull market is likely to drive household net wealth to a record high. In Q1 alone, household stock investment grew by $7t. Those capital gains should increase the wealth effect and provide a tailwind to further consumption growth.