Two interesting reports by the Bank of England
The discussion about what sort of landing the global economy will experience has taken centre stage once again. The CPI report last week in the U.S. showed that inflation appears to be more decisively trending down. At the same time resilient activity data has continued to surprise many. Housing starts, building permits and home sales seem to have found a floor, while the services sector continues to perform well. In Europe the headline CPI fell from 6.1% to 5.5% while Core CPI stayed unchanged in June at 5.4%. Compared to the Fed, the ECB has a little bit more to do for trends to be as convincing as those across the pond. However, we cannot ignore the fact that headline CPI inflation peaked about 8 months ago at close to twice the latest reading. Looking at GDP, Bloomberg consensus for QoQ growth in the U.S. is for it to be zero in Q3 and just below zero in Q4. In the Eurozone, after technically going through a recession with -0.1% QoQ growth both in Q4 2022 and Q1 2023, the consensus is for 0.2% QoQ growth for the remainder of the year and Q1 2024, with a mild pick up expected after that.
Last week’s CPI print in the U.S. has acted as a trigger of sorts for increasing calls for a soft landing. In this scenario inflation falls to more reasonable levels while growth falls significantly below trend but with no recession. If this is the case then the Fed should be comfortable to cut rates in the not too distant future, as inflation falls towards the target and the monetary policy rate is well above the neutral rate. Treasuries should be well supported in this scenario, however, we do note that the curve is already heavily inverted. It is difficult to forecast by how much more the 10Y UST can rally, but in the absence of a hard landing and the 10Y yield at roughly 175 bps below the monetary policy rate already, the scope for a further rally might be limited. In other words, Treasuries would be well supported and give reasonable returns, but whether or not they outperform other asset classes is a different matter.
In this soft landing scenario, by definition, default rates cannot be too high as if they were, then we would not be in a soft landing situation. A soft landing should therefore be supportive for spreads in those markets where spreads are cheap to their historic averages. There is even a case for spreads to perform well even in those markets where spreads are not particularly cheap, as lower inflation is good for real yields and nominal yields are still close to their highest in a decade. We tend to think that if this soft landing narrative continues to gain acceptance, then spread products will outperform a well-supported U.S. Treasury market. On top of underlying yields rallying, total returns would benefit from spread compression and higher carry than Treasuries.
In conclusion, there is no discussion that in a hard landing scenario, U.S. Treasuries would outperform credit by some margin. But if the central case becomes a soft landing, that would typically mean that credit outperforms. Treasuries would provide a reasonable return as well but credit would do better. With most default rate forecasts already slightly higher than long term averages for next year, the case for total returns in credit remains strong. Finally, it is worth noting that in the soft landing scenario described both government bonds and credit should do well, which is the best news that we can hope for as fixed income investors.