For all of 2022, we have focused on tighter monetary policy, discussing the dilemma faced by central banks (in ‘Czech Mate’) and their subsequent decision to prioritize the war on inflation (in ‘The Inflation Game’). As we peer into 2023, the themes have not only not changed – they’ve intensified. Consensus market hopes that the Fed would end their tightening campaign this autumn were squashed by Fed Chairman Powell at Jackson Hole.
Hopes that the ECB would continue their “gradual shift” were overturned abruptly by Christine Lagarde’s hawkish turn in September. Hopes that inflation might moderate were confounded by an elevated August US CPI release. Hopes of a gradual cooling in labor markets presaging a soft landing that many market participants want to see look wildly optimistic: every single one of the last 16 monthly non-farm payrolls prints has been above 290,000, with the last 3-month average at nearly 400,000.
The higher the readings on inflation, wages or jobs, the more central banks will need to jack up rates to recession-inducing levels. Weaker data would suggest a trend towards recession; stronger data, a need for more rate hikes. In a kind of heads-I-win-tails-you-lose central bank environment, until the war on inflation is won, the chance of a soft landing looks slim.
Tighter monetary policy of course has more than just economic consequences. For markets, moving rates into restrictive territory – at 75 bps clips, even in the Eurozone – means a tightening of financial conditions. Meanwhile quantitative tightening is set to accelerate, raising market volatility further. So how to position?
In yield curves, the macroeconomic and policy backdrop means front-end yields remain under upward pressure in the near term. The EUR yield curve has now started to flatten aggressively, a move we have been expecting all year. The EUR 2s10s swaps curve is now inverted, following the GBP SONIA curve, Korea and US Treasuries in a broadening wave of global curve flattening first presaged in Czechia right back in Q1.
Yet in time, these moves towards flat and inverted territory are likely to reach an inflection point. Even in the four recessions of the 1968-82 era, bond yields fell materially. By March 2023, on current pricing, year-on-year oil price changes are set to be negative. Broader commodity market moves are also softening: copper, lumber and various cyclical raw materials have already fallen heavily year to date as the growth outlook has darkened.
Headline inflation is already moderating in the US. But the rise in various core measures (including rents and wages) means central bank tightening is inked in for the near term.
As we head towards what looks like a market turn in rates, and the prospects for much better bond returns during recession, we consider three tests for duration. For portfolio construction, we continue to draw a distinction between the merits of yield curve versus duration strategies.
As we have mentioned before, to be profitable with large-duration trades, you have to call two things right: the cyclical outlook for growth, and the secular outlook for inflation. Yet for yield curves, the cyclical outlook does most of the job (because inflation premia exist across much of the yield curve and the secular level of rates and inflation is in any case somewhat embedded in official rates). We think there is much more visibility in the data on the cyclical growth outlook, than in the secular inflation outlook.
On the latter, questions remain unanswered: will wage rises lead to second-round effects (see the recent Dutch railway worker settlement for a 9.25% pay rise) or will demand destruction see sharp falls in prices (see the 30% fall in oil prices since March)? Which will dominate? Taking large bets on this unsettled debate looks an inappropriate way to manage client funds in our view, because the risk is still somewhat symmetrical. 2022 is already the worst year for fixed income total returns since 1788 by some counts.
Yet betting on a continuation of duration trends – trying to chase momentum for higher yields – looks risky. First, the twelve weeks since our last quarterly outlook have seen huge about-turns in rates: Schatz yields for example have moved from 1.20% down to 0.20% to back over 1.50%. But second, the extensive analysis we have undertaken for our latest Global Macro Quarterly meetings shows we should expect a turn – just not quite yet.
On the other hand, using historical frameworks to identify when yield curves have over-inverted to the point where the curve outlook is asymmetrical, remains a much better risk-reward approach in our view.
Yield curves are cyclically mean-reverting over time, be that in high inflation regimes (for example 1965-82), periods of inflation moderation (1982 to mid-1990s), or low inflation (mid-1990s to 2020). That means that excessively inverted yield curves are eventually likely to dis-invert and re-steepen. We therefore recommend using deep inversions in the US Treasury curve to scale into steepening positions – a trade that we think should make 100-150 bps of alpha on its own into H1 2023. Against that, we see some residual room for EUR curves to flatten.
As we said last quarter, we do not yet think recession is priced into high yield spreads. Since then, credit markets attempted a summer rally in July and early August, on the hope of a dovish Fed this autumn. That looked misplaced to us and we have used the rally to lighten up. Since mid-August, spreads have started to widen.
For sure, credit markets have cheapened this year – but only from their most expensive levels post-2008. This leaves the USD BBB OAS, the EUR BBB ASW and spreads for high yield markets sitting at (or even tighter than) their averages for the past quarter of a century. If history is any guide, an average spread is not the right level of compensation for recession.
Looking ahead, hopes for a turnaround look over-optimistic to us, given the monetary policy outlook, the reality of what turns credit bear markets around, and the relatively limited scope we see for game-changing fiscal policy. Only EUR swap spreads trade at recessionary or crisis levels.
Then there is sequencing. In the past 50 years, every single recessionary peak in credit spreads has been preceded by a peak in government bond yields. Usually by many months or even years. We do not believe this time will be different. We expect to see twin peaks: first in government bond yields, and then in credit spreads. The trouble is, the gap may be several months – and possibly many basis points – later.
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