CIO View

Does anybody remember October 13, 2022? Or August 14, 2008? Old hands in fixed income markets might well be familiar with these dates. Those were days when bonds reacted sharply to a surprising U.S. consumer price index (CPI) number. Like last Tuesday. A one-tenth miss to the downside in the U.S. CPI release was enough to trigger a good four standard deviation move in two-year yields. Does this one 0.1ppt surprise in an inflation number really change everything?

Not really. We believe that the CPI print needs to be seen in context with a series of weakish data releases from across the globe. Now, and that does make a difference, the U.S. seems to join the crowd: The October manufacturing & services ISMs were weak, we saw a miss in the non-farm payroll number, recent weekly claims data point to a substantial weakening in the labor market since early October, and so on. While still positive, the U.S. economic surprise indicator is heading south. This does indeed represent a change.

The background is that, despite the strong monetary tightening, the U.S. economy has held up remarkably well this year, while e.g. the European economy reacted almost in textbook style to the European Central Bank’s (ECB’s) rate hikes. Just recently, Eurostat reported a negative Q3 GDP print, while the U.S. grew at a 4.9% annualized rate. In the States, even interest rate-sensitive sectors like housing have stayed remarkably resilient so far. Housing starts decelerated last year, only to stabilize again in 2023, and the last number was still roughly in line with pre-pandemic levels, while the S&P/Case-Shiller U.S. National Home Price Index just made a new high. Moreover, the labor market remained quite robust despite the massive monetary tightening. A strong labor market in turn fosters consumption growth. All these factors taken together made markets increasingly nervous and got them guessing whether the U.S. economy might not be much more resilient than thought, meaning that another dose of monetary tightening would be needed in order to squeeze inflation out of the system.

Now, finally, evidence is mounting that the rate hikes have started to take their toll on the U.S. economy too, thus reducing the risk for further rate hikes, and supporting expectations of rate cuts in 2024. This week’s CPI print was probably just another, although important, piece of evidence.

Bond markets certainly appreciated the news, with U.S. yields falling by 20 basis points, and in the Euro zone by between 10 basis points for German Bunds and 20 basis points for Italian BTPs. That in turn pleased equity markets, which were up by about 3% (MSCI World). The dollar depreciated by 2% against the Euro.

Is the U.S. Federal Reserve (the Fed) about to make a U-turn now? We don't think so. Central bankers would like to see more evidence that the inflation genie is securely back in the bottle. Our feeling is that the Fed's current comfort zone for 10-year Treasuries lies between 4.5% and 5%. Late last week, given the strong decline in bond yields, Boston Fed President Susan Collins appeared on CNBC1, saying: "Just like I wouldn't overreact if things went in the direction that we weren't looking for, I don't overreact if we get some promising news." And she added: "I wouldn't take additional firming off the table." We would expect Fed officials to stick to hawkish language for the time being, thus keeping the bond markets from overdoing it and easing broad monetary conditions prematurely. We will need to be patient, possibly for more than half a year before the Fed will deliver its own contribution to make financial conditions a bit less restrictive, i.e. deliver a first rate cut. Being patient, however, is not a strength of financial markets.

Tomorrow’s Federal Open Market Committee (FOMC) meeting minutes might give some hints about current Fed thinking. Weekly claims data will already be released one day earlier on Wednesday. While our U.S. friends will celebrate Thanksgiving on Thursday, preliminary European November purchasing managers’ indices (PMIs) will shed some light on the state of the economy, as will the German IFO index on Friday.

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1. Source: Bloomberg, November 17, 2023.

Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect. Past performance is not a reliable indicator of future returns. Source: DWS Investment GmbH as of 11/20/23.