While the Fed doesn't expect to cut rates in 2023, markets continue to price in rate cuts in the back half of the year. 

3. Congress averts government shutdown: President Joe Biden signed into law a $1.7 trillion spending bill to fund the US government through its next fiscal year ending September 30, 2023. Among other provisions, the bill includes additional aid for Ukraine, emergency relief for Americans affected by natural disasters, changes to Medicaid, and a ban of Chinese-owned TikTok on federal government devices. Notably, the bill didn't include an expansion of the child tax credit, additional pandemic aid, or reforms to permitting of energy projects. The bill ensures the government won’t have to shut down—which last occurred over 35 days from December 2018 to January 2019. However, a debt-ceiling showdown still looms in 2023.

4. End of an era with a Bank of Japan (BOJ) shift: The BOJ made a surprise announcement that it would shift its flagship yield-curve¹ control policy, announcing an expansion of the target yield for 10-year Japanese government bonds (JGBs) to ±0.50% from ±0.25%. Most investors hadn't anticipated a widening of the yield target until the first half of 2023 at the earliest. In response, 10-year Japanese government bond yields rose to 0.4% from 0.25% (where they had been since early this year). Notably, the Japanese yen strengthened sharply after the announcement (FIGURE 3). 

Why does this matter? The timing of the announcement has surprised investors as it came earlier than expected. Only a few weeks ago, Governor Haruhiko Kuroda gave assurances that any speculation around tweaks to yield-curve control were premature because the BOJ wanted to see inflation sustainably at 2% accompanied by wage growth first. He even dismissed the latest 3.6% inflation print as temporary and driven by high import prices. While leads on wage growth are pointing upward, it doesn't appear that the conditions the BOJ had set to normalize policy were in place. 

Thanks to decades of accommodative monetary policy, the Japanese government debt has ballooned to more than $8.5 trillion, or 230% of GDP, enabled by low borrowing costs. This has pushed domestic investors to seek returns abroad. Much like Germany had long been the anchor of European rates, Japan has historically been the anchor of the global rates complex, so a substantial move in JGBs could push rates higher globally (more on this in What’s Keeping Us Up at Night). 

5. China’s anticipated re-opening has provided some optimism for global growth in 2023 with COVID-19 measures in the country loosened. In fact, online searches for international travel surged 850% within minutes after the news, according to local press. Chinese consumers had accumulated savings during 2022 as they refrained from spending (FIGURE 4). While there is potential pent-up demand, the impact on inflation remains an uncertainty—particularly if there are supply disruptions—and there might be some risk of having to pace the reopening should critical-care facilities become overwhelmed.

What's Keeping Us Up at Night

1. Bank of Japan and yield-curve control: As mentioned in the prior section, the impact of the BOJ’s shift in yield-curve control could be substantial and broad based across global financial markets. There are two reasons for this: the sheer size of the BOJ’s balance sheet, which stands at nearly 130% of Japan’s GDP, and the timing of the announcement—it came just one week after the European Central Bank (ECB), whose balance sheet is more than 60% of GDP, announced a hawkish shift in its policy. By comparison, the Fed’s balance sheet is slightly more than 30% of GDP (FIGURE 5).

By incentivizing Japanese investors back home by allowing them to earn higher yield on domestic debt, this could have serious repercussions for markets that have benefitted from inflows by Japanese investors. European yields have notably benefitted from the ECB’s quantitative-easing program, but the rally in euro-area sovereign bonds since 2015 has also been driven by Japanese institutional investors hunting for yield. France and Spain, in particular, could be vulnerable to a reversal, as cumulative investments there exceed €40bn and €30bn, respectively. The same could be said of Australia (€35bn invested since 2015), Canada (€20bn), and New Zealand (€3bn).

2. Tightening financial conditions have been reflected in business surveys for several months. Consumer spending has proven resilient thus far, with cracks first appearing in the housing market. We're now seeing more evidence that the economy is slowing given the lagged impact of significant tightening in monetary conditions. Consumers have been able to keep up their spending by drawing down their savings and increasing debt levels. These are unsustainable trends that increase the probability of recession in 2023, especially as the unemployment rate increases over the course of the year (FIGURE 6).

3. Russia/Ukraine war: The European Union (EU) agreed to implement a US$60/barrel price cap for Russian oil exports to other countries in order to limit profits and hamper its ability to fund the war in Ukraine. Russia has, thus far, been able to blunt the impact of sanctions by increasing production at steep discounts to China, India, and Turkey. Russia is reportedly considering oil production cuts in response to the EU price cap.

4. Trouble in real estate? At the beginning of December, markets were spooked by the limiting of withdrawals from a number of US- and UK-based property funds. Following substantial rate moves over the course of 2022, assets have repriced materially, and we’re seeing investors reconsider their strategic asset allocations. These property-fund withdrawals highlight the challenges of a liquid vehicle holding illiquid assets. However, we don't view this issue as having a direct impact on the commercial mortgage-backed securities sector, though we could see more impacts given weakening commercial real-estate fundamentals.