The Christmas lights may be pretty, but energy bills certainly aren’t this year.
Global bond yields fluctuated amid a busy week on the central bank front. A benign US CPI print, the second in succession, saw 10-year US Treasury yields fall sharply intra-day before retracing to 3.50%. This was typical of the recent price action, as elevated uncertainty on the economic and policy front keeps fixed income volatility high, even as other areas of the market, such as equities, remain calmer.
In general, markets remain somewhat directionless, struggling to sustain much traction as we enter the penultimate weeks of the year. Liquidity is declining and appetite to take on any new directional macro risk is diminishing.
As expected, the Fed raised rates 50bps to 4.25-4.5% with little change to its policy statement. Hawkish revisions to the inflation and growth forecasts now mean the majority of FOMC officials see rates above 5% at the end of 2023. This has opened a dichotomy between the Fed forecast and market pricing, the latter betting that rates will rise in 2023, but then fall back into the 4.25-4.5% region come the end of 2023.
On one hand, the reduction in the monthly pace of inflation prints has provided comfort that headline inflation has peaked and is trending lower into next year. However, Chair Powell continues to reiterate that we have ‘ways to go’ to get to 2% inflation on a sustainable basis, and that the labour market requires more of a shake up.
Moreover, Powell’s view that recent data merely reflects the policy restraint put in place this year means the Fed will want to keep an eye on any unwarranted loosening in financial conditions, consistent with his push back on the market narrative that a period of monetary tightening would quickly be followed by a reversal into rate cuts. We continue to think US Treasury yields will trend higher in the short term and into the first quarter of next year.
In Europe, European Central Bank (ECB) policymakers raised the deposit rate to 2%, with inflation forecasts raised higher in subsequent years. Lagarde subsequently guided markets to expect higher rates in the future, with further 50bps rate hikes a possibility, depending on incoming data.
We think the confidence the Eurozone economy could withstand higher rates could be founded on the more upbeat growth outlook, with the ECB forecasting a milder and shallower downturn over the coming years. Should the ECB outrun markets, the curve should start to invert further from here and price in a deeper downturn, with financial conditions at risk of becoming too tight for the coming year.
Overall, we think the combination of higher rates and QT (set to commence in March next year) will keep a lid on any significant spread tightening in Eurozone spreads in the near future.
In the UK, the Bank of England (BoE) voted to hike rates 50bps to 3.5% in a three-way split – with two members voting for rates to remain unchanged at 3%. We have noted in the past the BoE’s tendency to lean on the dovish side, acutely aware of the mortgage rate pass through on households already reeling from higher energy costs.
Our 2023 outlook continues to foresee the BoE under delivering versus market expectations, struggling to raise rates above 4%. Much of the BoE MPC believe they are already in deeply restrictive territory, and Governor Bailey himself has said the market-implied peak rate is too high.
We think this will only prolong the inflationary problem in the UK, as prices seep into wage and trade union negotiations. The combination of a relatively dovish central bank and structural economic vulnerability could be a toxic mix in 2023, and we stay short the pound in that respect.
Moreover, we expect inflation to remain stickier in the UK versus other markets, and given the current trade and external deficit, we struggle to envisage a world where gilt yields settle below 3% over the medium term.
Credit markets have generally trended better over the week, fuelled by seasonally low primary market activity, and lower levels of rate volatility (until yesterday pm), leading to continuing flows into the asset class. The recent rally has managed to extend further than many expected due to this combination, but the hawkish ECB has begun to turn the tide.
We have been expecting inflows into IG credit to remain a positive catalyst, and still think that this will be the case at the start of 2023. However, after recent moves we are happy to keep credit exposure close to home.
Looking ahead
We remain cautious in our outlook. Policymakers will be generally satisfied with recent data but are acutely aware of markets getting ahead of themselves. We continue to like selling into strength, and moving short risk in duration and credit appears to offer a more compelling risk/reward trade off, than jumping onto the price action and looking to follow the trend.
Heading into Christmas week, the market doesn’t want to believe Powell as he tries to push back on the recent loosening of financial conditions. As Rusty says in ‘Christmas Vacation’: “Think you might be overdoing it, dad?”. Well, Clark Griswold will certainly be thinking that when he gets his next energy bill! Inflation remains too high and Jerome Powell knows he needs to keep being the Grinch!
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