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In December, markets were living the rally that began in late October. Equity indices were at or near their all-time highs, with 10-year U.S. Treasury yields closing the year below 4% (3.87%) and German Bunds at 2%. The September (flat) yield curve could not hold its shape until the end of the year: the difference between the yields of the two-year and 10-year govies moved back into negative territory, reaching -38 basis points in the U.S. and -43 points in Germany and the UK. This indicates that market participants have returned to recession expectations and the imminent start of the cycle of rate cuts.
What to expect from bond yields?
The dynamics of prices of futures contracts on the Fed discount rate suggests that the first rate cut should take place in March, and by mid-summer the rate should reach the 4.75% level. Provided that such a scenario comes true, the yield on six-month T-bills should be close to 4.9%. However, at the moment the yields are above 5.25% and such a desynchronization can most likely be explained by the fact that in recent months the U.S. government has been borrowing funds “on the short end”, and has done so in large volumes. On the one hand, this is logical, as the general high level of yields is perceived by many as a temporary phenomenon, so an increase in the supply of securities at the short end of the curve and a decrease in supply at the far end will be less costly for the budget in the long run. But, on the other hand, the need for money is only partially satisfied, while the time of refinancing is not far off, which means that the increased supply will continue to put pressure on the cost of borrowing, thus allowing the hypothesis of another round of inflation, which, in turn, will significantly reduce the probability of interest rate cuts.
European and US equity markets
Gold is unable to hold on gains
China grows, Eurozone’s business activity continues to shrink
U.S. manufacturing sector continued to contract, but the rate of decline eased due to a slight recovery in production and an uptick in factory employment – the Institute for Supply Management reported that the manufacturing Purchasing Managers’ Index rose by 0.7 points to the 47.4 reading. Diminished demand played a role in pushing down prices at the factory level, indicating the potential persistence of deflation in the goods sector – the index measuring the prices paid by manufacturers declined to 45.2, down from November’s seven-month high of 49.9. The number of Americans filing new claims for unemployment benefits reached a two-month low of 202 000 (seasonally adjusted) in the week ending 30 December, reflecting the resilience of the labor market despite a gradual slowdown in demand for workers.
The decline in business activity in the Eurozone is still persistent, primarily due to an enduring downturn in the dominant services industry. This suggests that bloc’s economy has entered into a recession. HCOB’s Composite Purchasing Managers’ Index compiled by the S&P Global stood at 47.6. Also, Eurozone’s factory activity continued its contraction for the 18th consecutive month – HCOB’s final manufacturing PMI barely changed in December and was at 44.4 points, significantly below the 50 level.
China’s service sector was growing in December, supported by ongoing stimulus measures that boosted domestic demand. Additionally, the downturn in overseas orders saw some alleviation, contributing to a positive performance in the services sector – the Caixin Services PMI experienced robust growth in December, reaching 52.9 points, an acceleration from the previous month’s 51.5. China’s manufacturing sector, which holds a larger share of the economy than services, experienced a slight expansion in December. This was attributed to stronger increases in both output and new orders – the Caixin/S&P Global manufacturing PMI rose to 50.8 in December, up from 50.7 in November. The Caixin PMI presents a contrasting view compared to the official data, which revealed a greater-than-expected contraction in manufacturing activity during December.
Gold price, USD/oz
No changes to our trading strategies
For trading purposes, December gave us a chance to sell EUR/USD above 1.1000 level hence not changing our longer-term dollar-positive outlook and letting us doing more of the same, i.e. selling the pair above 1.1000 and buying near 1.05-1.0600 support zone. We want to see EUR/USD putting pressure on 1.0500 going into spring, as this would confirm our dollar-positive scenario. Certainly, we don’t want to see EUR/USD trading far above 1.1200 resistance level, as it would force us to re-think our strategy.
Metals were quite indecisive with gold still posing a question regarding its recent breakout validity. While metal’s charts are indeed encouraging, we do not want to proclaim victory and think that it might not be a bad idea to take partial profits at current price levels, keeping some powder dry for future trades. Silver looks neutral at current levels. We see the latest price action as gathering steam for an upside breakout, but XAG/USD 24-25 resistance is too strong of an obstacle at the moment, so a test of XAG/USD 21 support is not off the cards. We certainly would be trying to buy such dips (bearing in mind proper risk management, since market fluctuates with 10-20% price swings), looking for eventual capitulation of bears with initial aim being closer to 30 dollars per troy ounce mark.
December was as good of a month for bond buyers as November was. Indeed, we like the direction of the bond market, but at same time we would not be surprised to see some correction / consolidation going into spring. We would certainly use this price correction to add to our bond positions for a larger move higher going deeper into 2024. Oil and a gas are still a “tough call” as December was quite directionless. We would definitely want to keep small longs in energy sector, but shall wait for clearer signals to call next larger move.
Benchmark 10-year bond yields
So, where are we at the very beginning of 2024? Many equity indices of developed countries are at / near their historical highs, yields on 10-year treasuries are at their last year’s averages, and retail investors are almost fully invested. The conclusions are self-evident: the market needs a “détente”, at least temporarily. The correction of the S&P 500 to the levels of 4400-4500 looks quite appropriate, as well as the return of 10-year Treasury yields to the levels of 4.30-4.35% (at least for the sake of smoothing out the sharp movements of November-December).
Further happenings on the markets will be determined by economic data, primarily inflation and unemployment indicators, as well as (as usual) company reports. According to FactSet, in the 4th quarter of 2023, the profitability growth of companies included in the S&P 500 is expected to be 1.3% compared to the 3rd quarter. As most analysts note, given the expectation of a recession, most companies’ earnings forecasts have been underestimated, so surprises on the upside should be expected, which could help the market in the short-term.
High Yield bond Indexes
Source: Bloomberg and Signet Bank