The inversion of yield curves, the decline in oil prices, and the improvement of risky assets.
While the FTX saga conjures up a massive fraud comparable to the Enron bankruptcy in 2001, relative calm prevails in stock markets after a 10% rebound in the S&P 500. In China, less aggressive monetary policy is conveyed today by large investment inflows. The improvement relates to all risky assets, including European sovereign debt and credit as issues attract strong demand. Spreads are trending down. UK Budget was well received by the markets. However, the inversion of yield curves reminds us of the fragility of this rebound in stocks, which can still be compared to a jump in a bear market. In the US the 2-10 year spread is declining towards -70 basis points. The Fed is not done with monetary tightening, according to James Bullard who has triggered an extension of the monetary cycle towards 7% now.
The Fed is facing easy financial conditions
Autumn budget was eagerly awaited in the UK. Jeremy Hunt struck the balance, sparing a portion of his voters in light of the upcoming election while reassuring financial markets. The Chancellor of the Exchequer announced a two-step £55 billion consolidation plan with tax increases and spending cuts after 2025. Energy Shield costs £100 billion over time. The increase in income tax will pass through lowering the income threshold subject to the marginal rate of 45%. Transfers to families are planned as well as inflation-linked pensions. The need for public financing will reach 7.1% of GDP during the 2022-23 financial year before falling below 3% from 2025. The amount of bonds to be issued next year is also lower than expected (£170bn).
In the Eurozone, the German curve is also inverting, with the 30-year now trading below the 2% threshold.
In the eurozone, inflation held steady at 10.6% in October, three-quarters of the categories accelerating. Wage negotiations (+8.5% over 2 years for IG Metall in Germany) incorporate and maintain an inflationary environment. The ECB’s monetary tightening must continue. Reimbursement of expected TLTROs (Targeted Long-Term Refinancing Operations) is limited to €296 billion (14% of the total).
Since announcing a fall in inflation to 7.7%, the Fed is facing an easing of monetary conditions, possibly premature in light of recent economic data. Prices can be adjusted up to 7% according to James Bullard. This forecast contributed to the inversion of the curve as the 2-10 year spread reached -70 basis points at the end of the week. Speculative accounts are less inclined to sell the long end, and less sensitive to Fed decisions. The T bond briefly traded below 3.70% before bouncing back 10 basis points after the intervention of the St. Louis Fed Chairman. These comments led to a decline in inflation, which was initiated by the drop in oil prices (-$10 this week).
The credit market is recovering
In the Eurozone, the German curve is also inverting, with the 30-year now trading below the 2% threshold. The 50bp rise expected in December may not be enough to raise the lower level of long-term rates. A rise of 75 basis points or an expected quantitative tightening may be necessary to influence inflation. Swap spreads in favor of agency or supranational debt have been tightened. Hence, EU issues faced strong demand this week due to its attractive valuation. Sovereign spreads also show a net tightening, including Italian construction, which appears to ignore the €30 billion budget extension promised by the new government. French Treasuries equivalent, below the 50bp threshold, appear to be expensive. The PSPP (Public Sector Securities Purchase Program) forfeiture reinvestment will be a determining factor in the dynamics of sovereign spreads in 2023.
The credit market has recovered, thanks in part to the decline in risk-free interest rates. The average level of premiums on European investment grade (192 basis points versus bonds) is nearly 50 basis points below their 2022 highs. The balance of flows into ETFs has also improved in recent weeks. The high yield market takes advantage of this thriving environment. The deterioration in expected default rates next year seems absorbable given the current level of spreads.
In equity markets, the rebound in indices since October primarily reflects a drop in bearish bets. However, the beneficiaries returned to buying into the US markets. Global equity funds raised $22 billion this week, the best total for 35 weeks, with a slight outflow in Europe.