LONG-END YIELDS HAVE A MESSAGE

LONG-END YIELDS HAVE A MESSAGE Freya Beamish

Long-end yields have a message

The uptrend in yields reflects pricing of the new macro regime But regional variation in long-end moves and spreads tell us as much about investor ecosystem and monetary policy as they do about fiscal policy Follow the macro - US inflation is domestic with fiscal policy contributing whereas UK inflation is imported and yields reflect BoE pricing

The contrast between the message on fiscal policy from long UST yields versus Gilts is stark. For the US, fiscal policy is procyclical and contributes to our forecast for continuing above-target inflation. For the UK, the strong contribution of public GVA to total reflects not excess demand from fiscal policy but deficient demand from the private sector. High Bank Rate must be a contributing factor to that deficiency of domestic demand, while this feeds through to the long end, thanks in large part to a global shift towards hedge funds as the marginal long-end buyer, particularly in shocks. The low household savings rate in the US reflects a resilient economy, strong earnings growth and wealth effects plus a fiscal boost at the beginning of the year. The high savings rate in the UK reflects multiple things, with a common theme:

1. Deterioration of wealth because yields have risen creating capital losses

2. Attempts to pay down mortgages because yields have risen

3. Fears that the government will go on a tax raid because the fiscal position has deteriorated … largely because yields have risen

So the causality in the US and UK is diametrically opposed. In the US yields are rising because the savings rate is dropping and the government deficit is expanding, and that is before you get to the reinvigorated bid for debt from the corporate sector. In the UK the savings rate has fallen because yields are rising, while the government deficit is consolidating.

This flow of funds way of looking at things is paralleled by the implications for relative inflation rates in the next 18 months the the UK and the US. In a backward-looking sense and from a structural standpoint, the UK is just more exposed to the types of energy shocks that have plagued the global economy this decade. But the cyclical element likely dominates, and taking a forward-looking view, UK

inflation should be relatively less sticky compared to the past ten years and compared to other economies. Today's UK CPI print rose on energy, but even BoE research suggest that second-round effects will be smaller this time around, owing to labour market slack, with yesterday's labour market batch providing more evidence for that continued deterioration.

In contrast, the long-end UST yield rise is more justified by the domestic inflation outlook and the upward pull on Fed terminal rates. The FOMC is experiencing some inertia in getting started with hiking rates but the long-end is ready, as we sugested would be the case. A soft patch could further delay lift off, but we aren't convinced yet. Admittedly, retail sales figures alongside third-party data on vacancies provide a small pool of evidence to that effect. But broadening corporate earnings suggest any temporary consumer weakness will be short-lived - the jobs market should reaccelerate, aided by tariff refunds, while wage growth is picking up where it matters and real income growth will turn the corner. NFP and CPI prints to the downside look like noise to us at this stage. And beyond the debate over when exactly the Fed will start hiking, we have more conviction in the idea that the terminal rate will be higher than markets currently expect.

This note is more about a compare and contrast on the UK and the US, but we can't resist the temptation briefly to revisit JGBs. Japan's 30-10s spread is more about the BoJ's caution than anything else. We expect them to hike in September. The BoJ has a history of hiking too soon and killing the cycle. But with wage growth at 3.5%, the risks now seem small. We've been pointing to the demographic inflexion point leading to sustainable wage inflation for years, but even we were too cautious, initially on how high the Japanese terminal rate could go, and on the “natural rate of…