Bad Timing (for everyone)

More signs last week of the impressive resilience of the US labour market is the immediate cause of the additional surge in long-term US yields, but more fundamentally this heralds the fact that, unless the new administration radically changes course, adding more fiscal stimulus and another supply-side shock in the form of tariff hikes will come at a particularly bad time given the resistance of US inflation. We think there is still some space for one “last cut” in the first half of this year, with a low level of confidence, but we think a proper resumption of the Federal Reserve's (Fed) descent to accommodative territory will not happen before 2026, when the economy starts deteriorating in response to the implementation of “Trumpnomics”.

Higher yields, and a “stopped out” Fed are bad news for everyone. The UK has been a clear victim of bond market contagion. To the country’s usual source of vulnerability – particularly its chronic current account deficit – one needs to add the fiscal expansion announced in last October’s budget, and a “stagflationary” dataflow. This leaves the British government with only unpalatable solutions to deal with the effect of a rising debt servicing cost on its discretionary room for manoeuvre (cutting spending, hiking tax, or changing once again the fiscal rules). Still, we think the market is currently too timid on its expectations for rate cuts from the Bank of England. We think that the deterioration in the real economy will usher in a more convincing pace of disinflation, which will offer some capacity to offset the “bad winds” from the US bond market.

If contagion has been more measured in the Euro area, long-term rates have also been on the rise there and this goes beyond “self-inflicted damage” from member states and should be treated as a symmetric shock. This will add to the zone’s difficulties, and the latest surveys are concerning. We think the ECB needs to take the tightening in financial conditions on board to move quickly to neutral, and then into accommodative territory.