The Big Idea

Global strategy | Edging closer to adding duration

| July 7, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Excerpted from Santander CIB, Interest & Exchange, July 3, 2023, and edited for US Portfolio Strategy.

While the banking crisis that rattled financial markets less than three months ago seems to have had limited macroeconomic consequences so far, it is the relentless policy tightening by the world’s central banks that should keep investors worried. There is more reason to worry in some countries than in others. The US and euro zone both look set to get tighter. But the UK really stands out. Policy looks likely to go higher for much longer, bringing us closer to the point of adding duration.

Higher rates outweigh a modest tightening in credit

In the US, while borrowing from the Fed’s new Bank Term Funding Program seems to have stabilized at a pretty high $100 billion, commercial bank deposits have increased by $220 billion in the last six weeks and they now stand ‘just’ 4% below their 2022 highs and $3.8 trillion above pre-Covid levels. And that is despite the $900 billion that have entered US money market funds in the last 12 months. More importantly for the macro picture, bank loans are back above levels before the collapse of Silicon Valley Bank, even for commercial real estate (Exhibit 1).

Exhibit 1: US bank loans: weekly changes and total amount (USD bn)

Source: Bloomberg, Santander

So, although those March events will add some credit tightening to the main advanced economies, its degree will be limited compared to the tightening caused by the sheer amount of official rate increases. In fact, given their performance in previous cycles, both the availability of loans and actual loan volumes could deteriorate further in coming months (Exhibit 2 and Exhibit 3).

Exhibit 2: NFIB survey; lending conditions and rates

Source: Bloomberg, Santander

Exhibit 3: Euro area money aggregates and loan growth

Source: Bloomberg, Santander

Services and core inflation fail to follow the headline trend

In the meantime, the inflation picture does not seem to be evolving as policymakers probably would like. And while the headline component seems to have clearly left its peak behind and is decelerating fast– and inflation swaps suggest it will fall further in coming months – the same cannot be said of the core component (Exhibit 4). In fact, core CPI in the three major regions is still not only clearly above central banks’ medium-term targets, but at (or not far from) multi-year highs, especially in the UK (Exhibit 5).

Exhibit 4: US, UK and EUR headline inflation (YoY)

Source: Bloomberg, Santander

Exhibit 5: US, UK and EUR core inflation (YoY)

Source: Bloomberg, Santander

Obviously, the divergence between headline and core inflation is to a large extent caused by the base effect of energy prices given their sharp spike in the first half of 2022 following the Ukraine invasion. But the composition of the core component in these countries is also worth analyzing. While goods inflation is falling fast, services inflation remains much stickier. In fact, in the preliminary euro area June CPI release, services inflation reached an all-time high of 5.4% year-over-year, clearly above the 2010-2020 average of 1.5% (Exhibit 6). Interestingly, among the main sub-indices, services related to recreation, at 7.6% year-over-year, seem to be the fastest growing category.

Exhibit 6: Euro area goods vs. services inflation (YoY)

Source: Bloomberg, Santander

In the US, while still above target and above most goods prices, services inflation at least seems to have peaked recently (Exhibit 7). ‘Rent of Shelter’ is the main category in this index and, given its lagging relationship with house prices and the recent evolution of the latter, this component is likely to continue falling.

Exhibit 7: US headline, core, goods and services CPI (YoY)

Source: Bloomberg, Santander

Moreover, the closely watched ‘Services ex-Shelter’ category fell to 4.2% year-over-year in May 2023, from 5.2%. It is worth keeping an eye on this measure as, despite this good news, it has historically been highly correlated to labor costs, which have not seen any significant easing recently, given the extremely tight labor markets in these regions (Exhibit 8).

Exhibit 8: US Services ex-shelter CPI vs. ECI (QoQ)

Source: Bloomberg, Santander

Higher, for (much) longer

Given the surprising health of labor markets bearing despite aggressive policy tightening of the last 12 to 18 months and the resilience of core and services inflation, policymakers are finding that they have no choice but to lengthen their tightening cycles, not only aiming for higher terminal rates but also keeping them at ‘sufficiently restrictive’ levels for longer than previously anticipated. At the start off the year, advanced economies’ central banks looked likely to complete their tightening cycles by mid-year. But now some moderate further policy adjustments in the euro area and the US look likely in the second half of this year, and much tighter monetary policy in the UK with the BoE now expected to take Bank Rate to 6% before year-end (Exhibit 9).

Exhibit 9: Fed funds rate expectations by FOMC meeting (bp)

Source: Bloomberg, Santander

Interestingly, while the discounted peak in UK official rates is currently at record highs, the expected ECB and Federal Reserve terminal rates are, despite their recent adjustment, still below the early March (pre- SVB) levels (Exhibit 10). As a reminder, while in his March 7 report to Congress Fed Chair Powell discussed the possibility of accelerating the pace of the Fed’s policy adjustments, the reality is that the Fed ‘skipped’ the recent June FOMC in its already 500 bp-long tightening cycle. But what matters most is not whether the terminal fed funds rate is 5.25% or 5.75% but rather the fact that the Fed has successfully shifted market expectations of possible rate cuts at each of the upcoming FOMC meetings, to chances of potential hikes now priced in (Exhibit 11).

Exhibit 10: Official rate increases in major economies and expectations for 2H23

Source: Bloomberg, Santander

Exhibit 11: Discounted terminal rates for the ECB and the Fed

Source: Bloomberg, Santander

For the ECB, despite the aforementioned macro concerns, especially in Germany, following the ‘very likely’ hike on July 27, look for a heated debate when policymakers meet on September 14. But despite a further decline in headline inflation, the updated macro projections look unlikely to show a clear improvement in their long-term inflation expectations or deterioration in the labor markets and costs after the sharp upward revision to the 2023 and 2024 core inflation forecasts (+0.5% to 5.0% and 3.0%, respectively) and 2023-2025 unit labor costs. Only a material decline in August preliminary core and services inflation (to be released on 30 August) will likely make the ECB refrain from taking its DFR to 4%, although the central bank might try to join the ‘skip a meeting’ central bank camp, which already includes the RBA, the BoC and the Federal Reserve.

Rates pivoting around the curve’s very long end

In the recent period of sharp readjustment of policy expectations by the three major central banks, their 10-year yield has remained well correlated to front-end movements, but with relatively low betas, especially in the euro zone, while 10-year GBP and USD swaps have replicated 25% to 30% of the movement in 2-year rates (Exhibit 12). Interestingly, 30-year tenors actually declined moderately in the three markets in June. We might finally be close to the time to go clearly long duration. But we are not there yet.

Exhibit 12: Changes in 2y-10y-30y USD, GBP and EUR govies in June 2023

Source: Bloomberg, Santander

Antonio Villarroya
Banco Santander, S.A.


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Antonio Villarroya
Banco Santander S.A.

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