Q1 2024 déjà vu as inflation data soothes rates sell-off

Global rates markets rallied sharply on Wednesday after fixed income investors received some long-awaited good news in the shape of Consumer Price Index (CPI) data for December, which came in below consensus in both the US and the UK.

Before this rally, US Treasury (UST) and Gilt yields had each sold off by around 100bp after reaching low points in September last year when the Federal Reserve (Fed) started cutting rates (German Bund yields had sold off by only around 50bp over the same period). One of the underlying reasons for the recent selling pressure has been growing worries that inflation may not come back to target anytime soon, rendering central banks unable to cut interest rates as quickly as expected. Politics has added fuel to the fire, with the potentially inflationary policies of the incoming Trump administration creating uncertainty and the UK’s rising borrowing costs eating into what little fiscal headroom the government had left.

As usual with CPI releases, there were certain categories that surprised on the upside or the downside, there were base effects at play and some moves that seem counterintuitive at first glance. However, the bottom line is that these latest numbers hinted at inflation continuing to move slowly towards target, a trend that has come under increasing scrutiny in the last few months. Particularly encouraging was the US core CPI figure, which at 3.2% is revisiting its recent lows of Q3 2024, and the UK services inflation number, which fell to its lowest since March 2022 at 4.4%.

While this is welcome news, we did not stay up late celebrating yesterday, much as we didn’t despair in Q4 last year when certain measures suggested inflation progress was stalling. The moves in rates markets (and to a lesser extent risk assets) in the last few weeks are a stark reminder of the uncertainty that still dominates economic forecasts. The Fed cut rates by 50bp in September, and only three months later some members were expressing concern that rates were maybe not as restrictive as they thought. Indeed, earlier this week the financial press was carrying comments from some market participants about whether the Fed’s next move could be a hike. It isn’t hard to see a similarity here with early 2024, when markets were pricing in seven Fed cuts in January and zero cuts by May. By August we had calls for an emergency intra-meeting cut as US unemployment rose, but by year-end the dominant concern was that inflation was not coming down quickly enough as the economy and labour markets were too strong.

Just as was the case last year, chasing these market moves is unlikely to be a winning strategy. Of course, when markets move sharply opportunities to change a portfolio in a tactical manner do arise. These might include changing duration, selling positions that look expensive after a rally or adding positions in assets that have been overly punished for no good reason. But it is the medium-term macro view that drives the more important strategic decisions. Our base case remains that the US economy will grow at a decent pace in 2025, albeit a slower one compared to last year, while the UK and the Eurozone will continue to recover slowly with annual growth settling around the 1% mark. The inflation battle is not over yet, but the uncertainty at this stage has more to do with how slowly it might fall to target, rather than the possibility of a sustained rise in the coming quarters.

With balance sheets in good shape, default rates and non-performing loans at contained levels, and in the absence of a recession, credit should continue to outperform government bonds – as has been the case in this latest sell-off. Of course, given rich valuations and the current economic and geopolitical uncertainty, we think it makes sense to carry a higher than usual average credit rating and keep credit spread duration under control.

For fixed income investors the message is clear to us – keep calm and carry on.