Global financial markets have started 2023 well, thanks to supportive economic data and strong technical flows. Hopes for a slowdown in inflation were fueled by a favorable US PPI report this week, and with base effects causing energy prices to be declining year-on-year, this appears to portend a return of the CPI indices towards the target in the coming months, thus allowing for a dovish turn in monetary policy.
However, the decline in core prices will be much slower than the headline data and it will be core prices that will drive the actions of policy makers. With a still tight labor market and relatively healthy economic activity, it seems premature to believe that the Fed or the ECB will herald a turnaround, at least for a while longer.
Some believe that the Federal Reserve will adjust and follow the market, but this view seems to ignore the fact that the Financial Conditions Indices (FCI) have declined over the past three months. It also seems to us that policymakers are afraid of making a policy mistake by adopting a dovish stance too soon, and then keeping inflation elevated.
From this perspective, a slightly better growth environment over the course of the year would allow central banks to maintain a hawkish stance for now. On the Fed Funds front, we expect a rate above 5% in the spring before the FOMC stalls. In the months ahead, we believe a rate cut before the last quarter of the year is unlikely, unless there is a more sudden slowdown in economic activity during the summer.
Similarly, we expect rates in the Eurozone to exceed 3% in the spring, with the ECB likely to hike rates by 50 basis points at their next meeting. Rumors suggest that the Eurotower may be looking to slow the pace of monetary tightening in March, but one can assume these comments are coming more from the dovish front within the ECB, rather than reflecting a more mainstream assessment.
Indeed, Dutch central bank governor and ECB board member Klaas Knot was eager to signal a much more hawkish course. While we expect the debate within the Governing Council to intensify in the coming months, for the time being we believe the hawks are on the rise, given the extent of the inflation overshoot in 2022, which few had predicted.
In light of this, we moved to a more bearish stance on euro yields, reducing duration with the sale of BTP Italia on an outright basis. Eurozone sovereign spreads have performed with some degree of positive correlation to yields and we believe Italy’s spread could widen if Bund yields correct higher. German 10-year yields are down 50 basis points since early January, while Italian yields are down nearly 100 basis points.
In part, this movement reflected a surrender by those who had been holding short positions. However, with this base short eliminated and 10-year BTP yields falling below 3.8%, we believe buying interest in long-dated Italian bonds will be limited if investors can make 3% or more from their cash deposits over the next few months.
Meanwhile, UK data on wages and inflation suggest that price pressures are likely to remain higher than in other major developed economies in 2023. We still think the Bank of England will be very wary of taking rates to 4% or higher in the UK for fear of driving house prices down too much. This UK vulnerability, plus a structurally tight labor market and high fiscal deficit, make us bearish on the outlook for the months ahead, and this view appears to be most aptly expressed by an underweight to the pound.
We also continue to highlight the underlying vulnerability of the Gilt market, where the negative curve of demand continues to be a major issue. Put simply, if yields start to rise, pension liabilities decrease and therefore there is less demand for lower priced Gilts.
At a time when supply is problematically large and overseas investors are wary of UK assets, there is a risk of renewed turmoil on Gilts should any policy missteps occur. At least for now, the Sunak government will thank the mild winter and lower gas prices, but it’s unclear how long this luck will last.
Elsewhere, intense speculation ahead of the Bank of Japan monetary policy meeting saw us reduce our short JGB position. With 10-year swaps reaching 1% in Japan at the start of the week, we were pleased to trim our position ahead of the BoJ meeting, having generated positive returns to date. Following the meeting, yields fell and we were back short with 10-year swaps below 0.80%.
Bank of Japan Will Have to Raise The Ceiling on Purchase Yields
In our view, the Bank of Japan will have to raise the ceiling on purchase yields further in the coming months and eventually move away from YCC (yield curve control) policy altogether. Inflation is picking up and we believe it may continue to surprise to the upside, with more companies raising prices, now that the corporate shame factor of having to announce price increases appears to have dissipated.
The Bank of Japan has met its target of sustainable 2% inflation, but it is clear that Governor Kuroda is in a communication trap: he must show an unwavering commitment to maintaining the status quo, or else he will unleash a wave of speculation against Peg. This means that policy changes will have to come as a surprise, which is partly why the Bank of Japan has been cautious about signaling another change this week.
Over the past month, the Bank of Japan has had to buy bonds at an ever-faster pace, and figuratively speaking, it might appear that the Central Bank is materially stepping up its asset purchases, even as it approaches the “Stop” signal. Accordingly, we see the possibility of an interim policy change before the next scheduled meeting. This could come in the wake of inflation data or the announcement of the new BoJ governor in the middle of next month.
The notion that a Japanese policy change is a matter of “when” and not “if” has kept the Yen well supported over the past week. The decline in the exchange rate, on the back of a no-policy-change meeting, proved short-lived and it appears that the speculative community is still interested in adding to its long Yen positions.
Furthermore, the dollar continues to weaken and the DXY index remains under pressure. However, we believe that this trend may have petered out for now and that we may be at the extremes of a “dollar smile” (the theory that the US currency tends to appreciate relative to other currencies when the economies of United is extremely weak or strong). So far lower core rates have contributed to a weakening dollar, but if growth disappoints and drives core yields down again, the correlation that has been driving the dollar down could easily reverse.
Investor positioning has become to go short the dollar, with an overweight in emerging currencies. As a result, we were happy to reduce FX beta, having positive contributions on the Thai Baht and reducing the Brazilian Real, in order to adopt a neutral beta position.
At the start of the year, credit spreads soared and equities also posted positive returns. Supporting this price action are positive news on growth and inflation. However, we also note that there has been a strong desire to put liquidity to work and investors have concluded that, following a disastrous year for equity and fixed income asset class beta returns, 2022 will have to offer a more promising result. We would not be surprised if this desire to invest in cash begins to wane towards the end of the month, meaning that the strong technical supply that has been driving the markets begins to wane.
We will see substantial net fixed income supply in 2023, in part due to high fiscal deficits and the transformation of central banks from asset buyers to asset sellers. This could risk causing a crowding out effect in other sectors and while this factor has not impacted so far, it is possible that it limits the extent to which yields can rise, even if IG credit continues to appear well supported by fundamentals.
We remain more concerned about credit impairment in private markets broadly as we continue to maintain a favorable stance in financials, with banks helped by higher interest margins, even as provisions increase, in a growth environment deteriorating.
Looking at The Future
This weekend starts the new year in China. 2022 has turned into the Year of the Weeping Tiger, even if it ended on a hopeful note. 2023 marks the Year of the Rabbit, which seems to be off to a fast start. However, just as the rabbit runs out of steam after running to the front early in the race, we fear that financial markets could lose momentum in the weeks ahead.
This article is originally published on esgnews.it