Caution needed ahead of central bank decisions and fears of inflation uptick

Published on 29 January 2024

Markets should tread cautiously ahead of central banks interest rates decisions, says Ales Koutny head of international rates at Vanguard, and fears grow over reacceleration of inflation.

Koutny discusses how his buy-side desk is positioned ahead of a busy week and how he expects markets to react to the central banks Federal Reserve and Bank of England’s long-anticipated first interest rate decisions of 2024.

Across the globe, concerns are surfacing over the potential for a reacceleration of inflation amidst growing uncertainty over elections, future fiscal policies, and geopolitical instability. Koutny unpacks his views on the risk of an uptick in inflation to markets; he talks through how he is diversifying his portfolio in fixed income, and what he expects the liquidity environment to look like in 2024.

North America’s trading volumes and liquidity

  • Equities volumes elevated yet liquidity seemed to worsen week on week. US Investment grade volumes continue its high streak and bid-ask spreads have steadily tightened this January.
  • Data: Job Openings January 30, the Fed Interest Rate Decision January 31, and Non-Farm Payrolls February 2.
  • Primary equities: There are 5 IPOs expected to price at $1.74 billion. The largest expected is Amer Sports at $1.7 billion. 

Europe and the UK’s trading volumes and liquidity

  • EU equities volumes surged and liquidity was largely unchanged week on week. EU investment grade volumes remain elevated and liquidity is moderately improving this January.
  • Data: EU’s Growth Rate January 30, European Union’s  Inflation Rate, and Bank of England’s interest Rate Decision on February 1.
  • Primary equities: there are no IPOs expected to price on European exchanges this week.

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Transcript of interview:

Jo Gallager: Welcome to Trader TV This Week – your insight into how trading desks can prepare for the week ahead. I’m Jo Gallagher and today I’m joined by Ales Koutny at Vanguard to discuss the main topics and events leading this week.

Ales, welcome to the show.

Ales Koutny: Thanks, Joe. It’s great to be here.

Jo Gallager: Before we begin this, take a quick look at last week’s activity and what’s coming up.

In North America last week’s equities volumes continue to be elevated going into the end of January, as positive sentiment around the US economy and earnings spurred market activity. Liquidity, however, worsened week on week, yet bid-ask spreads were tighter than those seen for the same week for the last five years.

US investment grade volumes continued on their four week high streak, as January tends to be a busy month for fixed income. In addition to the record breaking issuance we’ve seen this year. Liquidity in US IG has steadily improved over the last four weeks and bid-ask spreads appear to be the tightest they’ve been since last October. We’ll have an eventful week coming up, as the fed would make its first interest rate decision of 2024 on Wednesday, and markets will be listening out for dovish or hawkish signals end of statement.

This week will also have job openings on Tuesday and non-farm payrolls on Friday. Markets will also be paying close attention to earnings this week, including results from heavyweight tech firms Microsoft, Apple, Alphabet and Amazon. In primary equities, there are five IPOs expected to price this week at $1.74 billion and aggregate proceeds. The largest expected del is Amer Sports, which is seeking to raise the bulk of that amount at 1.7 billion. If pressed, it would be the biggest consumer goods IPO since Rivian Automotive in November 2021.

In Europe and the UK, last week’s equities volumes surged week on week as markets reacted to earnings and the ECB decision to hold rates at 4.5%. With that, stock saw some of the highest levels on record for the same period for the last five years. Liquidity has remained largely unchanged over the past month, and bid-ask spreads appear stable for now.

Euro investment grade volumes remained elevated over the last two weeks, suggesting markets are seeking to lock in yields ahead of any rate cuts this year. Liquidity has gradually improved over the course of January, but bid-ask spreads are still much wider than historical averages for the same month between 2019 and 2020.

It will be a busy week in Europe in terms of economic indicators, as we have a reading on the eurozone’s growth rate on Tuesday, and we’ll have both the EUs inflation numbers and the Bank of England’s interest rate decision on Thursday. In primary equities, again, we should have another non eventful week with no IPOs expected to price on European exchanges.

Ales, lots to be discussed there. Markets will be honing in on the Central Bank’s decisions this week. Some of the first of 2024. How are you positioning going into this week and what should trading desks be preparing for?

Ales Koutny: This week will be very interesting. We have both the Federal Reserve and the Bank of England coming up. And that’s on the back of last week seen already the ECB and the Bank of Japan bringing some volatility to the markets as market participants try to square economic data and potential central bank rhetoric.

On the Bank of England front, we have been positioned for long duration trades in the UK, but we do think that the markets got a bit ahead of themselves here. Most expect a significant revision for their inflation forecast as a number of indicators have moved lower. We, on the other hand, think that due to financial conditions easing quite significantly, over a percent and a quarter from the last meeting, one would expect inflation expectations to be reduced somewhat in their NPR statement. We also think the easing of financial conditions will reduce the enthusiasm on that front.

We still believe that markets are hoping that dovish rhetoric could continue the massive rally in rates that we saw. But although we have participated that in the past, we have now pared back some of our positions and are waiting for better infra levels to resume the long duration trade.

Moving on to the Federal Reserve, we also expect the Fed to use this meeting as the first official opportunity to endorse or push back on potential rates cuts in March this year. While we have seen DC and especially core pricing coming significantly closer to the target or in some metrics even below target, we continue to expect economic conditions to accelerate. And overall, we should expect rates to back up a little bit before the cycle of cuts really starts.

Jo Gallager: 2024 is a year of a lot of uncertainty. We have a jammed elections calendar, very fiscal policies as well as an unstable geopolitical landscape. How concerned are you for a re-acceleration of inflation?

Ales Koutny: We have seen inflation moving significantly lower in the past few months, and a lot of people are expecting central banks to declare victory based on inflation returning somewhat close to or even below target in many jurisdictions. We think the most underpriced scenario for markets here is exactly what you”ve said. A re-acceleration of inflation could lead to a duration selloff when most of the street is already positioned for long duration trades. Overall, we think that some of the recent economic indicators in terms of activity, but also in terms of energy prices, including oil and gas, have started to pick it up. We are still awaiting potential announcements from China, which would be another positive surprise in terms of economic growth.

Jo Gallager: It’s been a record month in terms of bond issuance this January. Have you seen that demand come through and is now the time to be participating in fixed income?

Ales Koutny: Absolutely. We have seen books oversubscribed anywhere between 2 to 20 times over. A lot of that has been due to the idea that central banks have changed their reaction function. If we don’t see any surprises in inflation, that type of environment is perfect for fixed income investing. Not only do you have yields providing you a very large opportunity that you haven’t seen for the past 20 years, but also central banks have shown to be way more supportive on their approach to interest rates. Investors are rushing in and trying to lock in higher yields before potential cuts come through later in the year.

Our preferred expression is in periphery bonds in Europe, within countries such as Spain and Greece have improving fundamentals, but also the lower yield across the curves provide them an extra tailwind as the debt load of these countries proved challenging in the past, but can now be refinanced at slightly better levels. Moreover, in credit space, we start to see some interesting anomalies. Some part of the lower rate, the triple B space can sometimes trade cheaper than higher rated high yield bonds. That just shows that investors within the asset class are trying to grab as much yield as they can, and that creates dislocations that one can take advantage of. Fixed income as a whole continues to provide an excellent diversification for portfolios, and is the only asset class to protect investors on a recession.

Jo Gallager: How have you found liquidity in fixed income and how do you expect it to play out in 2024?

Ales Koutny: Liquidity can sometimes be challenging. As we’ve discussed before, new issues have been significantly oversubscribed, and yet volumes in the secondary markets have been much lower. We believe this trend will continue 2024. We are now undergoing what is normally the biggest period of issuance, and we think that traders are using this to position themselves for the end of the year. Central banks are expected to cut rates. We believe appetite for credit in general and fixed income more broadly will continue to increase. Yet a big factor in this equation will be fund flows. We have recently see an uptick in fund flows. And if this were to continue, we believe credit spreads should continue to tighten from here. Yet any volatility around data could put doubts into Central Bank expected path of rate cuts. That would potentially give traders interesting opportunities to add to their positions and position themselves across the board for lower yields.

Jo Gallager: Thank you, Ales for your insight and thank you for watching. This has been Trader TV This Week.