Muzinich Weekly Market Comment: Bonds get bashed

November 4, 2024

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In our latest roundup of the key developments in financial markets and economies, we explore the reasons for a significant sell off in government bond markets.

Last week saw a tsunami of unfriendly news for bond markets, driven by economic data, political policy shifts, and rising uncertainty.

Government bond volatility reached a twelve-month high (See Chart of the Week), with curves across Europe and the US bear flattening. Yields rose across the curve, with front-end yields climbing more aggressively. European government bonds underperformed significantly, with UK Gilts hit especially hard.

A costly rebuild

The catalyst for the selloff was Chancellor of the Exchequer Rachel Reeves’ Autumn Budget^[1] —Labour’s first in over a decade — which ruled out a return to austerity. Billed as a budget to “Rebuild Britain” and combat economic stagnation, it was described by the head of the Office for Budget Responsibility, Richard Hughes, as one of the largest increases in spending, tax, and borrowing in history.^[2]

The budget proposes an annual spending increase of nearly £70 billion (2% of GDP) over the next five years, funded partially by annual tax increases of £36 billion. This will push the tax take to a historic high of 38% of GDP by 2029/2030. The remaining balance will be funded through additional borrowing, averaging £32.3 billion per year, resulting in net debt reaching 97.1% of GDP by the end of the decade.

The UK Debt Management Office announced that gross financing needs for the 2024/25 fiscal year will be £22.2 billion higher than projected in April, with a cumulative increase of £145 billion over the following 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. This leaves the Bank of England’s (BoE) monetary policy committee with a dilemma, compelling it in the near term to reconsider the pace of interest-rate cuts and the appropriate neutral interest rate to meet its inflation objectives.

The overnight interest rate one-year forward is now 4.07%, 47 basis points higher than it was a month ago. This indicates the pace of monetary loosening will slow, with the neutral rate estimated about 50 basis points (bps) higher. Markets are pricing in an 80% likelihood that the BoE will cut rates by 25bps at its November meeting, but only a 54% probability of it following up with an additional 25bps cut in December.^[4]

Given the substantial increase in issuance ahead, the 10-year Gilt yield spiked 18bps. By comparison, the market fallout following Liz Truss and Kwasi Kwarteng’s unfunded proposed tax cuts in September 2022 led to a 59-basis-point spike. The International Monetary Fund, which heavily criticised the 2022 ‘mini’ budget, endorsed Reeves’ fiscal plans, citing the “needed increase in public investment” to drive growth.^[5]

Eurozone surprises

Elsewhere, stronger-than-expected economic growth and inflation data in the Eurozone lit the fuse for a selloff across the bond curve, pushing yields higher. The region surprised investors with a 0.4% quarter-on-quarter expansion in Q3, significantly above the market’s estimate of 0.2%.^[6] Key contributors included 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, Q3 growth of 0.4% was likely driven by a temporary boost from the Olympic and Paralympic Games held over the summer, which masked underlying economic weaknesses. Spain also outperformed (+0.8%), keeping its growth on track to reach 3% this year. These positive surprises outweighed weaker-than-expected results in Italy (0% versus +0.2% estimate), where growth was held back by a negative contribution from net trade.

On the inflation front, headline consumer prices rose more than anticipated in October, reaching 2% year-on-year,^[7] in line with the European Central Bank’s (ECB) target but above estimates of 1.9%. The primary driver was a smaller-than-expected decline in energy costs, while core inflation remained sticky, holding steady at 2.7% year-on-year.

The next ECB monetary policy meeting is in December. Markets widely expect a 25bps rate cut; however, considering this week’s robust data, the likelihood of a larger 50bps cut has decreased to 60%.^[8]

Dead heat

In the US, uncertainty around the Presidential election continues to grow, with The Economist's latest statistical model showing both candidates have a 50% chance of winning the presidency.^[9] The consensus view is that a Donald Trump victory would be slightly worse for bond markets than if Kamala Harris wins. As such, a red sweep on election day would likely lead to the most significant negative market reaction in the short term, while a blue sweep would be more favourable for bonds.

However, neither of these election outcomes is particularly favoured by political analysts. Adding to the uncertainty, robust economic data, including on consumer confidence, housing and employment, all point to an economy growing well above trend.

In Q3, the economy expanded 2.8% year-over-year, driven by a 3.7% rise in consumer spending – the fastest pace since the first quarter of 2023.^[10] This spending was broad-based, spanning autos, household furnishings, and recreational goods. In this environment, the path of least resistance for US government bonds is for yields to rise.

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

Chart of the week: Bond volatility surges

Source: ICE BofA Platform, MOVE Index, as of November 1, 2024. For illustrative purposes only, not to be construed as investment advice. Index selected as best proxy to highlight volatility in the bond market.

References

[1] HM Treasury, ‘Autumn Budget 2024,’ October 30, 2024
[2] Office for Budget Responsibility, ‘Economic and fiscal outlook,’ October 30, 2024
[3] Debt Management Office, ‘Revision to the DMO’s financing remit 2024-25,’ October 30, 2024
[4] Bloomberg, ‘World Interest Rate Probability,’ as of November 1, 2024
[5] The Guardian, ‘Reeves’s £40bn tax rises will boost growth ‘sustainably’, says IMF,’ October 31, 2024
[6] Eurostat, ‘Preliminary flash estimate for the third quarter of 2024,’ October 30, 2024
[7] Eurostat, ‘Euro area annual inflation rate and its main components,’ October 31, 2024
[8] Bloomberg, ‘World Interest Rate Probability,’ as of November 1, 2024
[9] The Economist, ‘New polls reset the presidential race to a dead heat,’ November 1, 2024
[10] Bureau of Economic Analysis, ‘Gross Domestic Product, Third Quarter 2024 (Advance Estimate),’ October 30, 2024
[11] Bloomberg, ‘World Interest Rate Probability,’ as of November 1, 2024

 

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