By François Rimeu, Senior Strategist, La Française AM
Yield curves continue to invert Aside from the persistence of artificial intelligence, the two major events in June were undoubtedly the continued inversion of the yield curves and the resilience of the US economy relative to Europe.
The yield curves in almost all developed countries continued to invert in the 2/10 range (but not exclusively). In the United States, the downturn triggered by the banking crisis in March has been completely nullified, while in other regions the pre-SVB (Silicon Valley Bank) levels have been joyously exceeded. Over the course of the month, the case of the United Kingdom is undoubtedly the most striking: between 23 May and 30 June, the 2/10-year yield curve went from +1 bp to -90 bps, i.e. 91 bps of inversion in just over a month! Even during the Liz Truss episode, the curves did not undergo such movements. These changes were linked both to the ongoing strong wage pressures (+7.2% over one year in the UK), which are forcing central banks to adopt aggressive policies (and therefore raise short-term rates), and to the fact that the market still does not anticipate any inflationary risk in the long term, with very prudent break-even inflation rates.
The levels reached are historic, and one must go back to the early 1980s to find equivalent rates. Historically, this is a sign that difficult times lie ahead in the medium term, but we must remember that as long as short-term interest rates are rising, the recession has not yet set in, despite the depressed sentiment revealed in soft data in most developed countries.
Despite such, real activity data is holding up well. Or rather, let's say that it is holding up very well in the United States; Europe is clinging on to its zero-growth rate. The dichotomy between America and Europe has rarely been so glaring.
United States and Europe: Diverging economic dynamics
In the United States, the real estate market has stabilised over the past six months and even seems to be recovering. The sharp rise in mortgage rates has thus far not had the desired effect, no doubt due to the impact of the CHIPS and IRA plans, with public investment taking over from private investment. The labour market remains as strong as ever, and although there are some signs of a slowdown, the decline has been very gradual. And as long as the labour market remains tight, wage inflation remains the Fed's (and other central banks') number one priority, since it is the main driver of core inflation. At the same time, industrial production is not collapsing despite alarming ISM and PMI data. Consumption is clearly holding up given that real wage inflation is now positive, and first quarter GDP has been revised up significantly from 1.4% to 2%. The second quarter should also show a similar growth rate (see Atlanta Fed or Dallas Fed). In short, from the Fed's point of view, there is no reason to stop raising rates. In Europe, while the situation on the labour market is similar (rising wage inflation, tense market), virtually all the other indicators have been lacklustre in recent months. A closer look at this data, however, reveals that these disappointments are predominantly in France and Germany, while they are almost non-existent in Spain and Portugal. Germany is still suffering from sluggish exports and increased competition in the automotive sector, while France is seeing a slowdown in the services sector. That said, despite the recent disappointments, this does not change the ECB's analysis of the economic situation: the labour market is too tense and wage inflation too high, therefore we need to continue raising rates.
For this reason, wage inflation will undoubtedly be the factor setting the tone for the rates hikes in the second half of the year; as long as it remains high, the curves are likely to continue their historic inversion.
More generally, we continue to prefer bonds to equities, both for valuation reasons and because we remain concerned about credit dynamics. The latest ECB surveys show no improvement on this front.
July/August outlook
We are at the end of the rate hike cycle, with the effects of lags still uncertain, the risk of a financial accident still present and the effects on credit dynamics still palpable. None of this is conducive to reckless risk-taking, especially in the equity markets, where we believe valuations remain excessive in the light of restrictive monetary policies. We are a little more comfortable with credit, where risk premiums are wider.
