Weekly Market Commentary (November 5, 2024)

Muzinich’s weekly take on key developments in financial markets and economies explores the reasons for a significant sell-off in government bond markets.

The past week has seen a tsunami of unfavorable news for bond markets, driven by economic data, policy changes and growing uncertainty.

Government bond volatility has reached its highest level in twelve months (see chart of the week), and the curves in Europe and the United States have flattened. Yields rose across the curve, with front-end yields rising more aggressively. European government bonds performed significantly worse, with UK gilts particularly hard hit.

A costly reconstruction

The catalyst for the fall was the fall budget[1] from Chancellor of the Exchequer Rachel Reeves – Labour’s first in over a decade – who ruled out a return to austerity. Billed as a Budget to “rebuild Britain” and tackle economic stagnation, it was described by the director of the Office for Budget Responsibility, Richard Hughes, as one of the biggest spending increases, of taxes and loans of history[2].

The budget proposes an annual spending increase of almost £70 billion (2% of GDP) over the next five years, financed in part by annual tax rises of £36 billion. This will bring compulsory deductions to a historic level of 38% of GDP by 2029/2030. The balance will be financed by additional borrowing, averaging £32.3 billion per year, so that net debt will reach 97.1% of GDP by the end of the decade.

The UK Debt Management Office has announced that gross financing requirements for the 2024/25 financial year will be £22.2 billion higher than forecast in April, with a cumulative increase of £145 billion over the next four years[3].

Growth, but at what cost?

The budget is expected to temporarily boost next year’s growth and inflation by 0.6% and 0.5%, respectively. The Bank of England’s (BoE) Monetary Policy Committee is therefore faced with a dilemma which requires it, in the short term, to reconsider the pace of interest rate cuts and the appropriate neutral interest rate for achieve its inflation targets.

The one-year overnight interest rate is now 4.07%, 47 basis points higher than a month ago. This indicates that the pace of monetary easing will slow, with the neutral rate estimated to be around 50 basis points (bps) higher. Markets give an 80% chance that the BoE will cut rates by 25 basis points at its November meeting, but only a 54% chance that it will make a further 25 basis point cut in December[4].

Given the substantial increase in upcoming issuance, the yield on the 10-year Gilt rose by 18 basis points. For comparison, the market fallout from the unfunded tax cuts proposed by Liz Truss and Kwasi Kwarteng in September 2022 resulted in a 59 basis point increase. The International Monetary Fund, which had strongly criticized the 2022 “mini” budget, approved Mr. Reeves’ fiscal plans, citing “the necessary increase in public investment” to stimulate growth[5].

The euro zone surprises

Furthermore, stronger-than-expected economic growth and inflation data in the euro zone triggered a downward movement on the bond curve, pushing yields higher. The region surprised investors with a 0.4% quarter-on-quarter expansion in the third quarter, significantly above the market estimate of 0.2%[6]. The main contributors were Germany (+0.2% versus -0.1% expected), where the economy will narrowly avoid a technical recession, defined as two consecutive quarters of negative growth.

In France, third-quarter growth of 0.4% was likely boosted by the summer Olympics and Paralympics, which masked underlying economic weaknesses. Spain also performed well (+0.8%), keeping its growth on track to reach 3% this year. These positive surprises outweighed the weaker than expected results in Italy (0% against an estimate of +0.2%), where growth was held back by a negative contribution from net trade.

On the inflation front, consumer prices rose more than expected in October, reaching 2% year-on-year[7]in line with the objective of the European Central Bank (ECB) but above estimates of 1.9%. The main factor was a smaller-than-expected fall in energy costs, while core inflation remained stable at 2.7% year-on-year.

The next ECB monetary policy meeting will take place in December. Markets generally expect a 25 basis point rate cut; However, given this week’s strong data, the likelihood of a larger 50 basis point cut has fallen to 60%[8].

Dead heat

In the United States, uncertainty around the presidential election continues to grow, with the latest statistical model from The Economist showing that both candidates have a 50% chance of winning the presidency[9]. The consensus is that a Donald Trump victory would be slightly worse for bond markets than a Kamala Harris victory. Thus, a red sweep on Election Day would likely result in the largest negative market reaction in the near term, while a blue sweep would be more favorable for bonds.

However, political analysts are not particularly favorable to either of these electoral outcomes. Adding to the uncertainty, strong economic data, including on consumer confidence, housing and employment, all indicate that the economy is growing well above trend.

In the third quarter, the economy grew 2.8% year-on-year, driven by a 3.7% increase in consumer spending, the fastest pace since the first quarter of 2023[10]. These expenses were widespread, covering automobiles, furnishings and leisure items. In this context, the path of least resistance for US government bonds is rising yields.

The overnight interest rate swap market currently implies an 84% probability that the Federal Reserve will cut policy rates by 25 basis points in November, with a 76% probability of consecutive 25 basis point cuts in November and December[11].

Chart of the Week: Bond Volatility

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