The Middle East is a Tinderbox Ready to Explode

Political

Summary:

Ever since the attacks carried out by Hamas against Israel on Oct 7, 2023, and the subsequent Israeli retaliatory air and ground campaign, there have been...

Ever since the attacks carried out by Hamas against Israel on Oct 7, 2023, and the subsequent Israeli retaliatory air and ground campaign, there have been fears that this latest confrontation between these two long-standing foes could escalate into a wider regional conflagration.

While this has not happened yet, the longer history of the Israeli-Palestinian and Arab-Israeli conflicts highlights potential for escalation.

With violence increasing across the wider Middle East, there are several potential pathways to escalation - via Iranian-sponsored terrorist groups, through worsening inter-state relations and by great powers being drawn into any of these conflicts.

Instability In Lebanon

First, Iranian proxies could increase their activities more significantly, including in what they might regard as a show of solidarity with Palestinians in general, and with Hamas and Palestinian Islamic Jihad, both of which are also sponsored by Iran as part of the so-called Axis of Resistance.

In the case of Lebanon-based Hezbollah, this would open a second front in northern Israel. The situation there has been tense for months. Several flare-ups have brought this escalation scenario close to reality, including Israel’s targeted assassination of senior Hezbollah leaders in southern Lebanon.

The United States' efforts to calm the situation have only been moderately successful, and indirect channels of communication appear to remain open between Israel and Hezbollah. This is particularly important as a more intense direct confrontation between Israel and Hezbollah could trigger another full-scale war as it did in 2006 - a grim prospect given Lebanon’s protracted political volatility and economic instability.

Strikes In Syria, Iraq, Pakistan Fuel Hostilities

US support for Israel may have become more equivocal over the past several months, but Washington is still seen as Tel-Aviv’s most important backer. This has exposed US military bases across the Middle East to a significant increase in attacks and prompted counter-strikes by US forces. Similar tit-for-tat escalations have now engulfed several other states across the region and beyond.

Israel struck an Iran-linked target in the Syrian capital, Damascus, while Jordan carried out attacks against alleged drug smugglers in Syria.

Adding to concerns over stability in Syria as a whole, Iran sent ballistic missiles against alleged Islamic State targets in Syria, in retaliation for an IS attack in Iran’s city of Kerman on Jan 3.

The same reason was given for Iranian strikes against Erbil in northern Iraq, which also targeted an alleged Israeli spy facility there, prompting widespread condemnation because of the risk of further destabilisation of an already volatile Iraq.

And in yet another demonstration of Iranian assertiveness, Tehran carried out air strikes against a base of Jaish al-Adl, a terrorist group operating in the Iran-Pakistan border area. This prompted retaliatory strikes from Pakistan two days later.

None of these incidents have escalated into prolonged cross-border hostilities yet, indicating that political leaders are still able to show a minimum of restraint. At the same time, the pattern of attacks also demonstrates the pivotal role that Iran is playing in any potential further escalation.

Flashpoints From the Israel-Hamas War

This is nowhere more obvious than in the case of the attacks by Iran-backed Houthis in Yemen against shipping lanes in the Red Sea.

These attacks pose a major threat to the global economy with about 12 per cent of international trade and more than US$1 trillion worth of goods passing through the Red Sea each year.

To protect the around 17,000 ships annually making the journey through the Suez Canal, the US and UK have carried out several strikes against Houthi targets in Yemen.

This instability off the coast of Yemen has also affected China’s export-oriented economy, and while Beijing has framed the situation in the Red Sea as a direct consequence of the Israel-Hamas war, it did not veto a United Nations Security Council resolution strongly condemning Houthi attacks.

The crisis in the Red Sea, however, has potential to undermine efforts to end Yemen’s civil war, in which the country’s internationally recognised government, militarily backed by Saudi Arabia and the United Arab Emirates, has fought the Houthis since 2015.

Because Saudi Arabia and Iran back different sides in this conflict, any further escalation could also derail further China-brokered rapprochement between these two regional rivals.

This, in turn, also decreases the likelihood of a sustainable solution for the crisis in Gaza. Hamas receives most of its backing from Iran and Qatar and is also able to fund-raise in Qatar itself.

In contrast, most other Arab states are keen to see Hamas defeated in Gaza, regardless of their support for the Palestinian cause.

This hostility towards Iranian proxies is even more obvious in the case of Hezbollah: With both the political and military wings Hezbollah banned by all the members of the Gulf Co-operation Council and most other Arab countries in North Africa, there should be no illusion about the fact that Hezbollah is seen as a threat by rulers across the Arab world - a perception that extends to Iran as the main sponsor of Hamas, Hezbollah and a range of other terrorist groups.

Amid these complex calculations by political leaders across the Middle East and beyond, Palestinian suffering in Gaza continues at an unprecedented level.

With Israeli Prime Minister Benjamin Netanyahu again explicitly ruling out the creation of Palestinian state, a pathway towards a settlement that could be broadly supported across the region and at the UN, is nowhere in sight. Netanyahu’s dangerous stance also, and perhaps fatally, undermines prospects for the rapprochement between Saudi Arabia and Israel that would be critical for sustainable peace in the Middle East.

With the Israel-Hamas war unlikely to end soon, let alone any prospects of a sustainable solution to the wider Arab-Israeli and Israeli-Palestinian conflict, the risk of escalation is likely to remain high and turn into reality – if not by design, then by miscalculation as the multiple crises engulfing the Middle East will eventually become unmanageable and spin out of control.

Source: CNA

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Central Bank

Economic

Fed warns against early rate cuts

It was an eventful week in global markets. The spotlight fell on the Federal Reserve, which shot down expectations it would cut interest rates in March, with Chairman Powell stressing that this is not the “base case” scenario.

Even though inflation has declined substantially, Powell downplayed speculation that rate cuts are just around the corner, arguing that the Fed is still not fully confident it has won the war. He pointed to solid economic growth, resilient consumer spending, and a tight labor market as factors that could keep inflation above 2% for some time.

Week Ahead – RBA Decision and US Data on the Menu_1

Reading between the lines, his broader message was that rates will eventually come down, but not quite as quickly as markets had hoped. As a result, traders scaled back bets on a March rate cut, slashing the probability to around 35% from 60% ahead of the Fed decision.

This translated into a boost for the US dollar. However, the dollar could not sustain those gains, mostly because the market didn’t change its view on the total amount of rate cuts that will be delivered this year – it simply pushed back the timing. Nearly six rate cuts are still priced in for the year.

A sharp decline in US bond yields was another element behind the dollar’s inability to rally, as lower yields diminish the dollar’s interest rate advantage. This slide was fueled by the government’s announcement that it will borrow less this quarter than previously estimated, as well as renewed concerns about the health of US regional banks after some poor earnings.

Week Ahead – RBA Decision and US Data on the Menu_2

Looking ahead, the main event next week will be the ISM non-manufacturing survey, due on Monday. This is one of the most important leading economic indicators of the US economy, and forecasts point to a meaningful increase in January. If that is the case, the market could continue to unwind some of its Fed rate cut bets, helping the dollar regain some momentum.

RBA meets, will it abandon its tightening bias?

Over in Australia, the Reserve Bank will meet on Tuesday. Market pricing suggests interest rates will be kept unchanged, so the focus will fall mostly on whether the central bank will keep further rate increases on the table.

The minutes of the December meeting showed that policymakers discussed another rate increase, but decided against it. Since then, incoming data has been on the weaker side with inflation slowing sharply in Q4, the labor market losing jobs, and consumer spending disappointing during the holiday season.

Even though policymakers may keep the option of raising rates again on the table, it is becoming clear that this is unlikely to happen. The domestic economy is losing steam and Australia’s largest trading partner – China – is in bad shape as it deals with the implosion of its property market.

Week Ahead – RBA Decision and US Data on the Menu_3

Therefore, even if the Australian dollar spikes higher in the case the RBA maintains a tightening bias, the general outlook for the currency seems gloomy. It would probably take a meaningful recovery in China and commodity prices, before the currency can stage a sustainable rally.

Speaking of China, the latest inflation stats will be released on Thursday. Forecasts suggest the world’s second largest economy sunk deeper into deflation in January, which could reignite concerns around the future outlook, keeping local stock markets and the China-linked Australian dollar on the defensive overall.

New Zealand and Canada release job numbers

Staying in the sphere of commodity currencies, employment data out of New Zealand and Canada will also be in focus on Tuesday and Friday, respectively.

In New Zealand, forecasts point to a looser labor market in Q4, with the unemployment rate projected to rise to 4.3% from 3.9% in the previous quarter and wage growth set to cool off. Most of this loosening reflects increasing labor supply amid record migration inflows, which will be welcome news for the Reserve Bank as it will help cool inflation.

Week Ahead – RBA Decision and US Data on the Menu_4

That said, the New Zealand dollar might react negatively to this dataset, as a softer labor market strengthens the case for cutting interest rates.

Over in Canada, the show will begin on Wednesday with the summary of deliberations from the latest Bank of Canada meeting. This is similar to the meeting minutes, and will give investors a detailed account of what was discussed. Then on Friday, the employment report for January will reveal whether the trend of a rising unemployment rate continues.

Source:XM

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Alex

Central Bank

Economic

If there's one thing you can say about United States Federal Reserve policymakers, it's that they don't make decisions on a whim. When the Federal Open Market Committee met on Wednesday (Jan 31), it held interest rates steady - as most observers expected. That marks six months since the Fed last changed the base rate.

And people should expect to wait a little while more: Fed chair Jerome Powell said a rate cut was “not likely” to come at the next meeting in March. But over the course of his news conference after the meeting, he emphasised that nothing is set in stone.

The Federal Reserve has what is called a dual mandate: Its job is to achieve maximum employment and keep prices stable. Often there's a trade-off between these goals: Cutting rates often helps with the former, while raising them helps with the latter.

And in recent months, controlling inflation has been the focus of Fed policy. In his remarks on Jan 31, Powell made it clear that Americans shouldn't expect the Fed to do anything to rates until the US gets closer to its target of 2 per cent inflation. And that could take some time.

“Let's be honest: this is a good economy”

There's a reason Powell and his fellow policymakers are focused on the 2 per cent inflation target. So long as consumer price index inflation is above 2 per cent, the concern is that any lowering of interest rates could stimulate the economy too much and reignite inflation.

Still, the federal funds rate, which helps determine mortgage and loan rates and quite a bit more, remains at 5.5 per cent, higher than it's been in 16 years. The Fed has raised rates 11 times since early 2022.

That aggressive rate-hiking has had the desired effect of putting the brakes on the economy. But it comes with some pain for borrowers - and some are now eager to bring rates back down.

Cutting rates usually makes sense when the economy is getting significantly worse, and there's not much reason to think that's happening now.

Fourth-quarter gross domestic product grew 3.3 per cent on an annualised basis, ending 2023 on a strong note. The economy added more than 2 million jobs over the course of 2023. And consumer price index inflation is running at about 3.3 per cent in December 2023.

“This is a good situation,” Powell said during his news conference. “Let's be honest: This is a good economy.”

Little Reason to Cut Interest Rates

So what comes next? The Fed recently indicated that it expects to cut rates three times in 2024. But as Powell was at pains to make clear, if the data changes, the Fed's decision-making will, too.

The US labour market data looks relatively sunny. There's greater balance between the number of people who want jobs and the number of open positions than there was last year.

Wage growth looks likely to continue at current rates. So unless there's a sharp increase in unemployment, which doesn't seem likely at the moment, there seems to be little reason to cut interest rates.

There's always a concern that keeping rates too high for too long may tip the economy into a recession. But recent history doesn't suggest that will happen.

No “Soft Landing” Yet

Taking a historical perspective can be revealing. The 30-year fixed mortgage rate is about 6.6 per cent - high by recent standards. However, back in 1998, the year I bought my first home, the rate was 6.9 per cent. At that time, it was a real deal.

Mortgage rates have been as high as 18 per cent if you go back to 1981. That's not to say either I or the Fed believe there's room to increase rates any time soon - just that rates are nowhere near record highs.

Powell did say there's no reason for any rate increases, so the current Federal funds rate of 5.5 per cent is likely the current cyclical peak.

The next meeting will start on Mar 19. The odds are that the US economy will continue to grow, and inflation will continue to moderate - however slowly. So I would expect the Fed to follow through on Powell's noncommittal prediction and hold off on cutting rates until later in the year.

So there's no soft landing yet - Powell said as much. But we look surprisingly close.

Source: Yahoo

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Thomas

Economic

Not bad. But not great either. That summed up the mood as the World Economic Forum ended in Davos last Friday with a panel on the state of the global economy. Not bad because most countries outperformed expectations of a year ago. Not bad because sharply rising interest rates didn't plunge the US, the eurozone and the UK into recession. Not bad because the war between Israel and Hamas has failed to send oil prices shooting above $100 a barrel.

Not great because central banks face a balancing act between cutting interest rates too quickly and reigniting inflation, and keeping them too high and plunging their economies into recession. Not great, because the early weeks of 2024 have led to a wider Middle East conflict, with implications for one of the world's main trade routes. And not great because – as Davos showed – the global economy is deeply fractured.

Inevitably, there is a risk that things will turn out badly in 2024. One leading global policymaker, speaking privately, said that repeated blows since 2020 meant it would be wise to be braced for the next surprise shock. Only the most incurable Davos optimist would quibble with that.

Washington and Beijing are in a grim struggle for economic supremacy. The gap between north and south is widening, and liberal democracy is being challenged by a new breed of autocrats. The planet continues to heat up. In a week that marks the 100th anniversary of Lenin's death, there are once again competing visions of what constitutes progress and success.

Even so, the death of globalisation has been much exaggerated. The reach of the multinational companies and the banks that continue to flock to the World Economic Forum were evidence of that. As is the rapid growth of artificial intelligence (AI), part of a tech revolution that cuts across borders and which is leaving national regulators floundering in its wake. A year ago, ChatGPT was in its infancy. This year, AI was central to the Davos debate, with those hailing its potential to help solve pressing problems – such as the climate crisis – ranged against those warning of its risks.

So globalisation is not dead, nor even on its last legs. The same goes for the demise of western liberal democracy. To be sure, productivity has been weak and living standards have been squeezed in recent years. Germany's finance minister, Christian Lindner, raised eyebrows when he said his country was the tired man of Europe. But there are good reasons why there are no TV pictures of asylum seekers trying to get into Russia or China.

What is true is that having been pushed on to the defensive, global capitalism is morphing into something different. Peak globalisation – along with peak Davos – happened a while ago, around the time of the global financial crisis of 2008, but it has been the repeated shocks since 2020 that have changed the dynamic.

Everything that has happened since the arrival of the Covid pandemic has pointed to a new paradigm: some call it de-globalisation, others call it – perhaps more accurately – “glocalisation”.

An ugly term, glocalisation is not the global free market, and it is not autarky (a nation that operates in a state of self-reliance), but something in between. It involves shorter supply chains, an emphasis on building back domestic manufacturing capacity, and a more strategic role for government. As with any form of mixed economy, the degree of glocalisation varies from country to country.

Where once Davos lionised frictionless supply chains stretching from China to the developed countries of Europe and North America, now there is a recognition that low cost is not everything and that there is value in governments knowing that they will not run short of vaccines, protective equipment, computer chips and energy. The attacks on cargo vessels in the Red Sea, necessitating much longer journeys around the Cape of Good Hope is the latest example of how vulnerable long supply chains have become. As Christine Lagarde, the president of the European Central Bank, said at the final Davos session: “We were relying on efficiency over security a little too much.” Lagarde noted, correctly, that a bit of rebalancing was no bad thing.

The long-term causes of glocalisation lie in the increasingly fractious relationship between the US and China – a relationship that has been deteriorating since Washington woke up to the threat posed by China's rapid growth and its clearly signalled plan to use its economic power to challenge the US's global hegemony. The US Chips Act and the Inflation Reduction Act are both examples of American determination to rebuild its industrial base through active government intervention.

But while the shift towards onshoring previously outsourced production would have happened anyway, it has certainly been accelerated by the events of the past four years: a pandemic, then supply chain bottlenecks, a surge in inflation, and the war in Ukraine.

The upshot is that industrial policy is no longer a dirty word, even in Davos. Indeed, there was plenty of interest at the WEF in what Labour's plans to boost the supply side of the UK amounted to.

Nick Stern, author of the seminal report on the economics of climate change, thinks there is a potential sweet spot where the demands for stronger growth and the fight against global heating intersect. AI, he says, can act as an accelerator to help developing countries both with climate change mitigation and adaptation. He is not blind to the pushback by the fossil fuel industry against steps to combat global heating, but thinks the positives outweigh the negatives.

Stern insists investing for good green projects would be good for growth and fiscally responsible. A green light for Labour's green growth plan, in other words. And glocalisation in action.

Source: The Guardian

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Justin

Economic

Political

The New Hampshire primary vote on 23 January launched one of the longest US general election campaigns on record with the two likeliest candidates already squaring off. American voters are bracing for the grinding months ahead.

Consider America’s political headlines from the perspective of an international investor. After decades of reliable growth and constant reinvention, the country’s unravelling political consensus and spendthrift habits have started to echo chaotic and cash-strapped Freedonia, the Marx brothers’ movie republic. Is now the time to cash out?

Rarely have voters (or investors) been able to choose between two candidates knowing exactly what they will get. Set aside their ages, personalities and looming court cases to look at their political programmes.

Biden versus Trump – again

President Joe Biden promises a traditional American role that strengthens alliances in Europe and Asia to stare down China and Russia. He wants more taxes on the rich, more ‘middle class’ jobs and more subsidies for the climate transition.

Former President Donald Trump wants to disengage from American commitments to Europe’s defence, de-couple from China and severely restrict immigration. He’d like to cut taxes again (especially for corporations), raise tariffs again (including on allies) and provide tax breaks for oil, gas and coal production.

In some ways, this election should be as simple for US voters as Ronald Reagan’s classic 1980 question when he defeated Jimmy Carter: ‘Are you better off today than you were four years ago?’ The economic data don’t actually give a clear answer. Excluding the disruption from the pandemic, unemployment and growth have been mostly the same under both presidents.

Real disposable incomes grew under Trump while any nominal gains under Biden have been eroded by higher inflation. Economists largely blame snarled supply chains for the higher prices. In retrospect, Biden and Federal Reserve Chair Jerome Powell bear some responsibility for large stimulus programmes and a late tightening cycle. But it’s also easy to forget the risks of a much deeper recession at the time.

The dirty secret is that the president doesn’t have much to do with the economy, which is buffeted by long economic cycles far beyond the reach of the Oval Office. Outside of the Fed most economic policies merely plant seeds that shape investment, wages and productivity over many years.

Whoever wins in November won’t get to plant the seeds he wants, since he is unlikely to have full control of Congress. So our global investor will have to look through the current political circus to see where America is headed under either outcome.

Knowns and unknowns

For all the uncertainty around the election on 5 November, the country’s trajectory is highly predictable in important ways.

First, there will be more confrontation with China. Trump has proposed a ban on all ‘essential’ imports (including steel, electronics and pharmaceuticals) within four years. Biden’s team has restored some military and economic consultations but continues to restrict trade and investment and threatens more sanctions over Beijing’s threats to Taiwan.

Second, the overall US market will be harder to crack amid a rising array of tariffs and subsidies. While Biden has not gone as far as Trump’s proposal for a sweeping 10% tariff on all imports, he is far more comfortable with trade restrictions and tax breaks he believes will protect American jobs.

Third, immigration laws will tighten even after the current border crisis is resolved. While Biden has tried to keep a door open for humanitarian refugees from Afghanistan, Ukraine and Venezuela, the country’s mood has aligned behind efforts to ‘control the border’, which may have long-term implications for the country’s workforce as fertility rates drop.

Fourth, debt will grow still further with neither candidate ready to seriously take on reform of social security and Medicare. With one party intent on cutting taxes and another still identifying areas needing more government support, the US will be borrowing much more.

Finally, regardless of the winner, America’s institutions – its military, courts, regulators and traditions – are in for significant stress. A Trump loss will leave many voters believing in a stolen election, while a Trump victory will hand power to a candidate who has promised ‘retribution’ against political opponents.

A more confrontational, protectionist and insular America hardly seems like a great formula to extend its record of economic vitality and creativity. But outsiders looking in will have to balance these risks with the country’s enduring attractions, including its geographic isolation and energy independence, deep capital markets and reserve currency, research universities and entrepreneurial culture.

Americans will have to grit their teeth and vote, because there really is a clear choice on policy, style and political philosophy. Global investors will try to look past the results in 2024 or even 2028 to assess if the American institutions that have mostly managed to keep political excess in line so far will withstand the current turmoil.

The United States of Freedonia is hardly inevitable, but neither is that durable liberal democracy we’d all like to build.

Source:Christopher Smart

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Kevin Du

Energy

Clean electricity generation in the United States hit new highs in 2023 but expanded by its smallest margin in more than a decade, due to below-normal wind speeds and a drop in hydro power output due to drought, data from think tank Ember shows.

U.S. clean generation grew by just 0.4% last year, the smallest annual increase since 2012, when clean output contracted due to a drop in both hydro and nuclear output. US Clean Electricity Momentum Stalls Slightly in 2023_1

US Clean Electricity Momentum Stalls Slightly in 2023_1

The slow growth pace came despite additions to renewable energy supply capacity throughout the country, and resulted in the first contraction in overall electricity generation since COVID-19 lockdowns stifled total energy use in 2020.

Wind Curbs

U.S. wind supply capacity is estimated to have increased by between 7.1 gigawatts (GW) and 12 GW in 2023, according to the U.S. Department of Energy, although the exact degree of expansion is still to be confirmed.

The average annual increase in U.S. wind capacity between 2015 and 2022 was 9.5 GW, so a further steep climb in wind capacity was expected in 2023.

However, a mix of supply chain disruptions alongside increases in materials and labour costs caused a sharp slowdown in the momentum of wind project installations last year.

Nonetheless, the total footprint of U.S. electricity generation from wind sites is widely assumed to have expanded in 2023 over 2022's total, and should have resulted in a commensurate increase in total wind electricity generation. US Clean Electricity Momentum Stalls Slightly in 2023_2

US Clean Electricity Momentum Stalls Slightly in 2023_2

However, unusually low wind speeds - especially during April, May, June and November - resulted in a nearly 3% drop in total wind electricity output last year, Ember data shows.

Drought-Hit Hydro

U.S. power providers were also hit by a more than 7% drop in output from hydropower sites due in 2023 to drought in key hydro generation areas, especially in western states.

In combination, hydro and wind facilities generated around 665 terawatt hours (TWh) of electricity in 2023, compared to 695 TWh in 2022, Ember data shows.

A roughly 19% rise in solar output to 243 TWh helped offset some of lower wind and hydro output, and alongside fairly steady nuclear output allowed power firms to boost clean electricity generation to a record of 1,750 TWh, up from 1,744 TWh in 2022.

Fossil Cuts Sustain Energy Transition Momentum

The share of clean power in total generation hit a new high of 41.1% in 2023 thanks in large part to continued cuts to the use of coal in national electricity production.

Coal-fired electricity output shrank by 19% in 2023 to around 672 TWh, and the lowest total since at least 2000.

Gas-fired electricity increased by nearly 7% from 2022's total to 1,804 TWh, but total electricity output from fossil fuels contracted by 2% last year to its lowest tally since 2020.

Fossil fuels still accounted for around 59% of total U.S. electricity generation last year, but should see a larger decline in the generation mix going forward once output from wind sites pick up due to a recovery in wind speeds and from further expansions in grid-connected capacity.

Alongside expansions to solar generation capacity - which the U.S. Department of Energy estimates grew from 17 GW in 2022 to 31 GW in 2023 - higher wind power looks set help U.S. clean electricity generation regain momentum in 2024, and should keep the country's energy transition goals on track.

Source: Reuters

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SAXO

Bond

Weakening growth, inflation, and a shaky geopolitical environment

Markets should be ready for another bumpy ride in 2024. Although sluggish growth and declining inflation have set the grounds for lower interest rates, monetary policy uncertainty and geopolitical tensions will remain.

As central banks started hiking policy rates aggressively, the probability of a recession increased among leading economists and bond futures priced prematurely a soon to come cutting cycle. However, central banks stuck to their “higher for longer” narrative upsetting markets throughout 2023. Fast forward, and policy rates have risen to their highest level in more than fifteen years. Despite economic woes, policymakers are not expecting to cut rates aggressively in 2024. However, a recession in the US economy could quickly change this.

A fragile geopolitical landscape will add to market volatility. The US is facing geopolitical tensions in Ukraine, Israel, and Taiwan. With the US going to the polls in November, the political situation will likely move to a gridlock in 2024, lowering the fiscal impulse and adding to growth uncertainty.

The above calls for caution from central banks when tightening the economy further or easing it too quickly, implying higher volatility in bond markets.

The bond market offers attractive prospects for investors

Bond investors are presented with the opportunity to lock in one of the highest yields in more than ten years. Higher yields do not only mean higher returns, but also a lower probability of bonds posting a negative return even if yields rise slightly again. Bonds on Everybody's Lips_1

With central banks likely cutting rates slowly, the lagged transmission of aggressive monetary policies from 2023 will continue to tighten financial conditions in the new year. This would favor extending duration and quality in the medium term.

There are three possible scenarios for developed market sovereign bonds in 2024:

1. Soft landing scenario: the battle against inflation is over, and a deep recession is avoided, causing central banks to cut rates slightly, but not aggressively. Yield curves would bull steepen, with 10-year yields adjusting moderately lower from where they are today.

2. Hard landing scenario: a deep recession forces central banks to cut rates aggressively, provoking a deep bull steepening of yield curves. Rates would fall considerably across tenors.

3. The 70s scenario: inflation reignites, forcing central banks to hike again. This would see yield curves bear flattening, with front-term yields offering a considerable pickup over long-term yields.

Quality is king

Deteriorating economic activity and high rates do not bode well for risky assets, which could lead to higher corporate bond spreads amid slowing revenues and compressed margins.

While yields on corporate bonds in the US and Europe have risen together with sovereign yields, the pickup that investment-grade corporate bonds offer over their benchmarks is well below the 2010-2020 average.

When looking at junk, the picture is even more depressing. USD high yield bonds pay 260 basis points over comparable investment grade bonds, a level in line with pre-Covid valuations when the Fed was stimulating the economy through quantitative easing and interest rates were less than half what they are today. In Europe, junk pays 310 basis points over high-grade peers, reflecting a more challenging macroeconomic backdrop.

Therefore, we see better value in developed market sovereigns, although a selective approach for corporate bonds remains compelling. Bonds on Everybody's Lips_2