Global inflation – Mixed signals.
Over the past two weeks, markets received mixed signals about global inflation. In the US, the July print gave investors signs of hope. Headline inflation remained flat on a monthly basis, and core underdelivered relative to consensus. On a year on year basis, headline inflation was up 8.5%, vs 9.1% in June. Most of the drop was due to a contraction in energy components, thanks for lower oil, but core components showed unexpected declines too, pointing to a broader easing of supply-driven inflation. In Europe, on the other side, inflation signals are stickier. The final read for July CPI inflation remained just shy of 9%, and producer prices accelerated dramatically in Germany, to almost 40% in July. Gas prices remain volatile, with further Nord Stream maintenance announced by Russia being read as a further geopolitical threat. In this context, rates volatility has risen again. US 10y Treasuries have bottomed below 2.60% in early August to re-accelerate their move higher last week, and are now just shy of 3%. Main indexes of rates vol are now 15% off the lows reached right after the US inflation print. Markets now price at a 60% chance of a 75bp Fed hike in September, and a terminal rate close to 3.7% to be reached in 1Q23. The Powell speech at Jackson Hole later this week will shed further light on Fed communication, and it is going to be the key pivot for rates markets into early September. Overall we think inflation momentum in the US has improved, but the market has correctly re-priced a hawkish Fed after too much excitement post the print. So upside on the US front-end is likely limited. The long-end has more space to correct, especially if recession fears for 4Q22 prove unwarranted. In Europe, inflation momentum is still on the upside and gas prices add to the risk. We thus think rates have more upside, especially given low levels and the newly introduced spread-control instrument.
Credit markets – Rally takes a break.
Credit market conditions have eased substantially in August. European high yield CDS spreads tightened from a high of almost 650 in July to almost 450 in mid-August. Since then, index has retraced some 60bp, but levels remain well below mid-summer. A similar dynamic can be seen in US high yield and emerging markets. As we highlighted in our latest Algebris Bullet, spread levels prevailing in late July looked too high vs economic fundamentals. We continue to find valuations attractive on a medium term basis, but we recognize that technicals are a bit less favourable on a one-month basis. First, the move stronger in risk seen after US CPI led to a broad de-hedging (though not a strong addition to cash bonds), so we can see some of these hedges coming back in case of some bad news hitting markets. Second, Powell is likely to re-iterate a relatively hawkish message at Jackson Hole this week. Third, Russia pressure on Europe is likely to increase entering into Fall, as the additional NS1 maintenance suggests. We thus remain wary of volatility in risk markets over the next few weeks but look at a re-test of recent highs in credit spreads as an opportunity to add risk.
Algebris Investments’ Global Credit Team
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