Overview
So far in 2024 the experience of holding US bonds has been one of unrequited anticipation. Back in December, US Federal Reserve Chair Jerome Powell dropped heavy hints that the long-awaited ‘pivot’ was coming and the Fed would soon start to cut interest rates.
Since then, the persistence of US inflation has caused a delay. Non-US developed market bonds meanwhile have outperformed as growth elsewhere has weakened and inflation indicators have cooled. Spreads have reached extreme levels, and the consensus is that this state of affairs will continue. In our view, the stage is set for a period of US bond outperformance when, as so often happens, the consensus is confounded.
Of course, there needs to be a catalyst to shift the narrative. Here are three candidates.
ONE: US core inflation continues to fall
Inflation for US core consumer prices reached a three- year low in April and posted the first month-on-month fall since October. There are good reasons to expect continued downward momentum in both core services and goods inflation.
An important component of core services inflation is owners’ equivalent rent (OER), which calculates what someone who owns a property would pay in rent to live there. While it isn’t a direct measure of what a homeowner actually pays, it nonetheless affects the inflation figures and so influences monetary policy.
Leading indicators suggest OER should continue to fall: Chart 1 shows the New Tenant Repeat Rent (NTRR) index, which is based on the leases of tenants who have recently moved house and as such tends to lead changes in overall average rents.
Prices for core goods also remain well above levels consistent with real input cost inflation. So any slowdown in demand should also support continued disinflation, which in turn would give the Fed more space to cut rates.
TWO: US consumers break under pressure
That slowdown in demand looks to us to be a question of ‘when’ not ‘if’. There is a shrinking portion of Americans who are able to keep spending in the way they’ve been doing since the pandemic. The stress of consumers at the lower end is well known, but those on middle-incomes are seeing real income growth at just 25 per cent of 2023 levels, as well as depleted excess savings and ongoing cost of living pressures.
As people have felt the squeeze of rising costs there’s been a steady increase in people working multiple jobs to keep pace. But that can’t continue indefinitely.
THREE: The labour market takes a turn (and proves it’s less robust than people think)
Although most recent employment data has surprised to the upside, leading indicators of employment growth now point to a slowdown. These include the National Federation of Independent Business (NFIB) small business survey of employment intentions which, barring a recent small uptick, has been in a downtrend going back more than six months, as well as the quits rate (those who have chosen to leave their job).
The recent employment strength reflected in non-farm payrolls has been dominated by non-cyclical sectors like education, government employment, and parts of healthcare. Most other sectors are flat or shedding jobs.
Part-time employment has been on a sharp upward trend relative to full-time employment. The speed of this change is similar to what was seen in 2001 and 2007 and has historically led to a broader employment slowdown.
Rates are too restrictive
Our thesis is that the neutral real policy interest rate is far below where we are right now. We think the Fed will need to carry out cuts at a speed greater than currently priced by the market as inflation falls and real policy rates become more restrictive as a result. The speed of disinflation will dictate the speed at which these cuts happen, absent any shocks to the growth and labour market outlook which would accelerate the pace.
The wait for the cutting cycle to begin may have dragged on, but reasons to expect the current consensus will be upended are only growing stronger. High quality US bonds should fare well if and when this shift occurs.
