Direct From Dowding: January 2025

Hello there, and good morning. Good afternoon, depending where you're dialling in from. Great to be online again in 2025, sharing some of our thoughts and ideas in terms of how we see the world ahead of us going into the coming months ahead.

So, having sort of got back to my screens at the start of last week, I guess, kicking off in terms of thoughts around what's going on in the US. And I think the 1st thing to share very clearly is that the US economy continues to retain plenty of momentum when we are looking at the data. It seems very much as if the US economy continues to fire on all cylinders.

And so recession risk continues to look very low in our eyes. Certainly at the start of the year there may be greater uncertainties towards the end of 2025, but for the time being the economy looks to be in a healthy situation.

The Fed obviously has lowered interest rates by 100 basis points at the back end of last year, and now has articulated, if anything, they're likely to be on hold for a little time.

In terms of assessing the Fed, the way that we would be looking at the Fed reaction function is that the Fed is minded to carry on easing rates at some future point, on the assumption that interest rates remain at a level which are above what is deemed to be the neutral level of interest rates. We are currently around 4.3%, which is certainly 100 basis points higher than many on the Fed would tend to think the long-term neutral level of interest rates will be, so there is an inclination towards cutting interest rates. But I'd suggest we'll only see those rate cuts if we see inflation resuming its downward trajectory through the course of the months ahead.

Last week we actually had a slightly better inflation print, better than expected. It came out at 3.2 year over year on the core measure. But before you get too carried away, and markets did get pretty balled up on this inflation print, I would sort of highlight that core CPI, if you actually graph, it has actually been at this level of 3.2 or 3.3 for around about 6 for the last 6 months.

So although there's some relief that inflation pressure is not building to the upside. I do think you'll need to see a renewed downtrend in inflation if the Fed is going to return to cutting rates later in the year, or you might need to see a slowing in growth.

But to the contrary, to the upside, I think that where we would look at the Fed in terms of its reaction function in terms of a prospective rate hike, I think here you would only be seeing this, if you saw core CPI 4%, which would tie in around the core PC, which is the Fed's favoured measure, hitting around 3.5.

If you're kind of there, and moving on an upward trend, I think the Fed will have no choice but to tighten policy once more and push interest rates higher, though for the time being that looks relatively unlikely over the course of the coming months.

Now the thing that investors have been asking themselves, the question, though, is that with Trump coming in. And obviously it's Inauguration Day today, isn't it? With that taking place today what policies may be enacted? And what is that going to mean in terms of that inflation path?

Now, I think the 1st thing you would say is, if you look at what is being done on the fiscal side. everything that we're hearing so far from the Trump team suggests that they are looking to certainly renew the past tax cuts, deliver some additional tax cuts over and above that.

But it does look like there will also be some measures to actually curb some government spending. Obviously, Elon Musk has got to get his teeth into this in terms of the department of Government efficiency that he is now heading. And I think that the right baseline assessment for the fiscal deficit in the US is broadly unchanged on a year-over-year basis around 6.5 to 7%.

In fact, the risk on the deficit to being a higher deficit would actually kick in if you ended up with much weaker growth. But as long as growth is pretty robust you still have pretty healthy levels of tax receipts. We think that fiscal policy is kind of going unch year over year. And so from that perspective, it's not clear that fiscal policy per se is going to be a big, positive, inflationary driver.

Similarly, when it comes to tariffs, there is going to be action on tariffs, and here we await what comes out in terms of the executive orders in the course of the coming days, in terms of what we see on that particular topic. But I would highlight here that if you do end up with tariffs being imposed, but the dollar has simultaneously moved stronger again, the tariff price increases should be offset by that currency effect.

So again, it's not clear that trade policy is going to be that inflationary, either. I think tariffs would be more inflationary if you do end up with tariffs, and also a weaker dollar at the same time, that would be a more problematic outcome. But in as much as we have seen a strengthening of the dollar to date, I think that may negate some of those concerns.

And that then just leaves us with policies around things like immigration, where we do think the labour market will be tightening. One of the executive orders that will go out today will be really clamping down on the border to stop immigrants coming into the United States. And although net net that will lead to some tightening of the labour market, that could put some upward pressure on the wages, we would observe that the labour market is weaker than it was a year ago, and so we're not too worried about overheating in the labour market just at this particular juncture.

Furthermore, another executive order that will be announced today, which will be “drill drill drill” when it comes to oil exploration, if anything is a potential catalyst for slightly lower oil prices that in turn could actually be a little bit better for inflation. But you put all of these factors together, and I think that our baseline again would be inflation more or less, going sideways.

When we look at the pricing of the US yield curve with two-year rates around 4.25, we think we're pretty much bang on fair value for the front end of the curve with cash rates of 4.3. And that being the case, we think that now is a time when you can be pretty neutral in terms of your thinking around US duration.

In terms of the yield curve, the yield curve did move steeper towards the end of the year. This is something that we've been calling for, but it was very much a bear steepening move. And so, we've been sort of happy to see how this has taken place. And indeed, the 30 year part of the curve hit 5% in terms of yields which was actually a target for us to actually de-risk some of our short, the long end of the curve, flatten out a little bit of that curve risk, because although we're inclined to think that the curve will ultimately move steeper, we think that ultimately a much bigger curve steepening probably needs to be led by front end rates going down in terms of a bull steepening move, rather than the continuation of the bear steepening we've had up until this point.

So, I think the message coming into the start of the year, having actually made some money out of the rates trades in the last couple of weeks. But the message in the here and now is actually, there are probably more interesting trades away from the US rates market than focusing on the US rates market in and of itself, just at this particular moment.

Before I move elsewhere, though just a few words on tariffs, because I think one of the things we have highlighted is we've tended to think there are opportunities to be had in FX and to be along the dollar. And here we do think that US growth exceptionalism, coupled with trade policy, that is pushing towards tariffs will end up favouring the dollar over the course of the next couple of months.

Now, today, the dollar has actually gone weaker today on a report coming out of “The Wall Street Journal” suggesting that in this early batch of exec orders we won't actually have one on a global tariff. That's something that maybe some market participants have been fearing. But I would say, be cautious with the price action here, because the thing that we feel confident about with Trump taking over is that we are going to be in a bit of a noisy period.

You may end up with one headline, pushing markets one way. Another headline can go the other way, and we are only a couple of tweets away from something more significant. And so I wouldn't be at all surprised if by this time next week Trump hasn't put something on “Truth Social” sort of articulating his plans to hit other countries with tariffs.

And actually the announcement effect, I think, actually may take some market participants by degree of surprise. So, I continue to think that when it comes to FX we're likely to see a challenge of parity on Euro/Dollar. I actually will continue to look for parity, to break to the downside, because where we think the US economy continues to have that momentum when we flip our thinking across the Atlantic to what's going on in Europe, the picture just looks a lot weaker.

When we look at the eurozone economy here. I mean, if you look at sentiment, if you look at where we stand coming into the year, it feels like a lot of northern economy continues to bump along the bottom, not really experiencing very much growth at all.

I've covered before how high energy costs are a factor that have been a real source of malaise in terms of manufacturing industry. I'd also highlight the fact that weak confidence is actually impairing investment. It's impairing spending on big ticket items. Consumers are being scared off from spending. given a relatively pessimistic economic outlook which becomes somewhat self fulfilling.

And so this idea that we are in a bit of a malaise in the context of the eurozone economy, I think, is going to be something which is going to be a factor that continues to be a theme in the course of the coming months.

And on the back of this we do think that whereas the Federal Reserve is likely to be keeping rates on hold for the next number of months. we are expecting the ECB to cut interest rates in each of the three coming quarters. So rates today at 2.75 in the eurozone, we see rates down towards 2% towards the back end of the year.

I'd also highlight in Europe as well. This is a year where we think there will be ongoing sort of episodes of volatility around politics. What we're looking at here principally is around France as a bit of a catalyst. That said in France we can't see new elections until the summer, so just in the short term, we think France goes a bit quiet, we feel that Le Pen will lend the support that Bayrou needs to actually push a budget through, and you could see in the short term a bit of a retracement rally in French spreads.

But ultimately, if we do see France trading tighter relative to Germany, we think that France will be a good short again in the middle of the year. If spreads get inside 70-basis points, because we do think it will be politically expedient for Le Pen to collapse the government to call fresh elections over the course of the summer months, and we could well expect to see National Rally actually leading a government come the end of the year.

And we think against that OATs are likely to continue to underperform in 2025, as they did underperform in 2024. And we're happy to own other European government bonds in place of French assets.

Otherwise switching across the Channel. Here in the UK we've seen a period where the gilt market has been underperforming. Though that said last week we did actually see a rally in gilt yields on the better of inflation print.

But here we think that the inflation number that we got last week may be as good as it gets for the UK. There was a bit of a quirky anomaly. If you look at airfares, they were actually down 26% year over year, not because airfares have got any cheaper. But it's just because the survey day in 2024 is on the 10th of the month. It's normally done closer to Christmas, so it didn't actually capture the full move up in Christmas airfares. Those of us who travel at that time of year, you know, there's a bit of a Christmas/New Year tax when it comes to hotels and airfares, and what have you. So we do expect some of this good news on inflation that we saw last week in the UK to be corrected at the next monthly print.

Moreover we continue to look at wages being incompatible with the 2% inflation target the Bank of England has, given how weak productivity growth is. And looking forward in the UK we already know that we're going to see higher council taxes, higher utility bills, higher food prices. We're looking at companies passing on increased costs coming through the rise in the national insurance taxes and what have you.

And so from that perspective it just looks to us that inflation is likely to be sticky. So, although the Bank of England may cut rates in February, because they're desperate to cut if they can cut, they will. And we think the last data last week may actually give them a window to actually lower rates from 4. 75 to 4.5. We think that may well be the only rate cut that we see in the UK this year, because inflation does seem too high, and the Bank of England just doesn't really have room to ease.

It will also be interesting, we've seen in the US if you end up with the central bank easing, but actually, the economy is not actually that weak, you can actually see longer dated yields rise. And this is something we saw in Q4 in the context of the US, as the Fed was actually cutting, yields actually climbed, didn't they?

And so I wonder again that you could see the Bank of England cutting rates in February, but that isn't necessarily going to help the long end of the bond market. And here there's going to be ongoing focus on the UK’s government finances. Ultimately, if we do see borrowing costs moving up, then Rachel Reeves is going to be forced into either raising taxes or cutting spending.

In a way, the UK government is kind of a hostage to the market. Here it will be the market that decides what needs to be done fiscally, yay, or nay. And from that point of view obviously, very exposed to what's happening in the US treasury yields, but thematically speaking, this thought that the UK doesn't really have room to ease monetary policy, it doesn't have room to ease fiscal policy, we think, represents something of a stagflationary threat in the UK, which could well see the pound underperforming in the FX space we think over the course of the coming months. So that would tend to be one of our favoured FX shorts.

By contrast turning to a brighter topic, an area of more optimism is Japan, it seems to us that the economy there continues to go quietly in the right direction. We see ongoing evidence that the wage round that takes place this quarter, the Shunto, is likely to be relatively strong. We're looking at 5%, plus, which is obviously would be the, I mean we saw last year's Shunto was the highest they’d seen for about 40 years.

We'd expect a repeat of the same in 2025, and that's helping to lift inflation, which is already above the 2% target. We think it continues to stay above that target. And with that being the case, there's a green light for the BoJ to continue to normalise monetary policy we think, during the course of this year. That being the case, we're looking for a move from 25 basis points to 50 basis points at the BoJ meeting at the end of this week on Friday, and that to be followed by two further moves this year, taking rates at the end of the year to 1% in terms of Japanese cash rates.

As that occurs, we're looking for JGB yields to move higher. The 10 year last week hit 1.25 in terms of yields. And now we've been very bearish on JGBs entering that position actually 18 months ago, when yields were at 0.25. So, having seen that travel 100 basis points, we actually reduced our position size, we reduced our short duration stance on Japan a bit, but we continue to sit materially short of Japan duration. We're just not limit short anymore because we think that yields are likely to move to somewhere just above 1.5% come the end of the year.

But in the here and now we think there's probably more upside more money to be made in FX. As we've mentioned in US rates, we think there's more opportunity, perhaps, in FX right now than there is in yen rates. And from that point of view we have been increasing our positioning on the yen, where we continue to have the yen as our most favoured currency on the view that, as the policy differential normalises, we're likely to see the yen perform, and the yen has been a very undervalued currency for a long period of time.

And so this may well be the year where the yen claws back some of that lost ground. Indeed, one of the things highlighting how cheap Japan has been, I thought, was shown in a piece of data shown last week, where we actually saw the volume of tourists coming to Japan, actually up 36% year over year, a staggering increase in tourism in Japan.

I think a lot of people were cottoning on to the idea that Japan is super cheap. It's a lovely place to visit, and a great place to take a vacation if you can do it at this particular point in time, so I think the story there is on track. It is a good one.

I also think that when it comes to tariffs Japan is likely to get off better than many European countries actually fare under Trump. I think that if anything Trump sees Japan as part of the solution to the US's over reliance on China in that part of the world. And so I think that when you see the application of how tariffs are handed down there will be a bit of a selective country by country sort of application. And I think that, relatively speaking, Japan is going to get off lightly, whereas there will be other countries in Asia, take somewhere like Thailand, we think gets hit pretty hard largely because a lot of the Thailand exports going to the US are actually disguised Chinese imports. And so going after those hidden, disguised Chinese imports, I think, will be front and centre in terms of some of the US's thinking. So that will be interesting to see how that unfolds in the days ahead.

We retain quite a cautious stance when it comes to China. We continue to see ongoing policy easing in China, but it continues to be piecemeal. It continues to be a bit of a time. We don't really see enough changing. We still don't see the agenda changing towards more of a domestic consumption, orientated push largely because we feel that Xi fears losing control. If you end up empowering the consumer, you don't get to control the consumer. And this is something that doesn't sit well with Japanese policymakers.

So we're still quite cautious there and otherwise in EM, we have a bit of a cautious stance given that we think we're against this backdrop where we're not seeing US rate cuts. We think the dollar can be firm, that creates a more challenging backdrop thematically. Obviously, within EM, we think there are some great opportunities investing on a relative value basis. We can always pick our favourite longs as well as identify some shorts that we want to run.

So I think it's still a great environment for making alpha. But it's probably more of an alpha generating sort of backdrop than it is one which is great for Beta coming into the current year.

And I think that's the same message we'd also have when it comes to credit asset classes. Credit did very well in 2024, largely as some of the recession fears that people had at the start of last year started to die away. The fact that recession risk remains low continues to mean that credit continues to do pretty okay in the here and now, but we do think the valuations are pretty compressed. It is going to be difficult for spreads to rally very much further from here.

And also one of the other things that we would highlight is that we think that under a Trump presidency we are going to see episodes of volatility. And this is a really important message, because I think that in a way, if you think that volatility is what you should expect then you can almost sort of come up with an investment view where you want to be de-risking when markets are trading well, pairing investment positioning down to flat waiting for the volatility to strike and valuations to get cheaper. And that's when you want to re-engage in the market again.

And that's kind of what we've been doing actually over the course of the last couple of weeks we've been paring down our positioning in credit. We've become very bullish in credit into the election back at the end of September, when we thought that Trump was going to win, we thought that would lead to a contraction of risk premium. That pro-growth agenda, we thought would end up favouring spreads, and that trade has worked out very well.

But we now think it's a time to be booking profits a time to be paring down exposure, a time to be flattening out risk. And we think if we can flatten out risk, we kind of feel half confident that there'll be a moment at some point in the next couple of months where spreads end up wider than they currently are, and that's probably a moment that you can then re-engage and look to get back into trades you like at better levels.

And so that sort of having a mental template of when you want to own risk this year, and when you want to step back. I think will be important to be disciplined. I think it will be in that way a bit more of a trading market than a market where you can say this is a theme that you can jump on and ride all year long.

And so, looking at this sort of theme of volatility, driven by politics and policy, driven by what's coming out of Trump, I think it's something that sits with us at the start of the year, and having got off to a good start in the last couple of weeks, having made money out of our Japan trades having made money on the US curve, having made money in credit, and now having flattened risk down. I think it's a time to sit back, watch and wait, and see what comes next, because I think that there is a danger that we go towards complacency with Trump. There'll be things that he does, which are great. There will be things that he does which I think are going to be pretty disastrous. So volatility, I think, is a message as we start the New Year.

With that I'm looking at my clock. I've been speaking for 25 min, this isn’t meant to be a rant. I'd now like to turn over to some questions that some of you may have posted online again, slido.com, and the code DFD 20, Jan. And it looks like we have a couple on here already.

So, picking these up, the 1st question is on the UK market. “Will the UK government be obliged to raise more taxes or cut spending to satisfy the bond market vigilantes?”

Well, here I think the message is that the market will dictate what is going to be necessary in terms of any fiscal tightening. If yields are moving higher, if borrowing costs are moving higher, then the OBR rules will actually dictate that the government needs to actually act in order to make a fiscal adjustment. Now, I think if they are pushed to make a fiscal adjustment, the temptation will be to fiddle with some of the assumptions in sort of the out years, four or five years ahead without actually taking any policy action.

But if they're looking at, if they're being pushed to take action, and all they do are tinker at the edges, then I think credibility could be pushed, could be challenged. There may be more of a push from the bond market to actually see some tangible action on the part of the government.

So, we'll have to see how this plays out. I would say a lot of this is really dependent on what happens in terms of US yields. If we see US yields moving materially higher in the next couple of months, I think the UK is going to be forced in this direction. However, if treasuries remain stable, or if treasury yields are moving a bit lower, I think the UK gets away with it.

So, I think this is less about bond vigilantes specifically going after the UK. It's just that the UK government is having to learn that actually as a sovereign these days, it doesn't really get to call the shots in the way it once did. Given that debt levels are where they currently are. Given that the UK's credibility in financial markets has been materially damaged a couple of years ago under Liz Truss, and from that point of view it remains a bit of a canary in the coal mine.

Moving to the next question, “Do you see opportunities in real yields, where and how to monetize it?”

So, on real yields, look, I think it's an interesting question. We did have some positive views on real yields that we implemented back end of Q3 last year, both in Euro real yields as well as in US real yields, essentially looking for inflation to actually trend somewhat higher. At this particular juncture though we've actually taken off those positions, we feel that they've worked, we are less clear in terms of the inflation trend in the here and now.

Something that you would say about real yields a lot of this in terms of the near-term price action can be heavily influenced by movements in oil prices. And, as I said just earlier on the call, one of the things I'm confident that we'll be getting in terms of one of the 1st exec orders today is going to be action in terms of increasing the oil production coming out of the United States. There will be that encouragement to go ahead and ramp production.

And so from that point of view, it may actually put a bit of a cap on oil prices. There could even be a bit of a move lower in oil prices. If you saw that, then obviously real yields might actually end up moving in the other direction. So for us, this isn't a particularly clear moment to actually take a view in that space as mentioned here. And now we're actually stepping back just a little bit.

Then a 3rd question is, “What would be the relationship between the new Canadian Government and the White House look like?”

Well, that's quite a simple one, because we're pretty convinced that the Conservatives under Poilievre are going to win. And we actually think a Poilievre government will actually look like a mini Trump government in many areas of policy. So, I think that the relationship between Ottawa and DC will be much warmer than it currently is.

I think that part of Trump's desire to put Canada in the crosshairs and threaten it with tariffs, and threaten it with the takeover of the 51st state, or something like that. A lot of that comes down to the fact that he has real disdain for Trudeau and everything that Trudeau stands for. I think that under a Poilievre government I think it will be very different.

Obviously, we've had Mark Carney come into the race to actually lead the Liberals, but to me it seems like Mark Carney is a bit of a busted flush at the minute. Most of what he's touching is turning pretty wrong, and if anything since he actually entered the race, there's no evidence that the Liberal party are getting a bounce. If anything, the Conservatives continue to strengthen their lead.

I would say, therefore, that with this sort of Canada thinking, I actually think that closer to the election at the time of the election on a Poilievre win for the Conservatives, I think there could well be a moment you actually want to buy the Canadian dollar. I'm just not convinced that it's just yet. It feels a bit too early just at the moment, and I'm sure that Trump will be mischievous in terms of some of his comments on “Truth Social” in between now and then.

With that I'm at time, thanks for joining the call. Hope some of those comments were of interest. These are calls that are taking place on a monthly basis. This one was a slightly rusty one. I think I'm just back from a very nice holiday, but there'll be plenty to talk about, I'm sure, over the course of the coming weeks and months, so do join again in a month from now. But for now all the best in markets. Thanks very much. Bye.