What’s Driving Markets…
1. Further moderating inflation pressures: Inflation slowed more than forecasted at both the headline and core level during November, stoking some hope that the Federal Reserve (Fed) could slow the pace of its tightening campaign. The headline Consumer Price Index (CPI) moderated to 7.1% year-over-year—the slowest pace of the year—while core CPI, which excludes volatile food and energy prices, decelerated to 6.0% year-over-year (FIGURE 1). The details showed significant easing of core goods prices, reflecting a combination of weaker demand, improving supply conditions, and easing pipeline cost pressures. Meanwhile, shelter prices remained sticky, though some higher-frequency housing indicators suggest these prices could also moderate over the next 6-12 months.
US CPI Year-Over-Year by Components (%)
Chart data as of February 2017–February 2022. The CPI in the US is defined by the Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” Sources: Bloomberg, Bureau of Labor Statistics.
2. Fed pivot talk is premature: The Fed hiked rates by 0.50% to a range of 4.25%-4.50% at its December meeting, in line with market expectations. However, the Fed surprised markets a bit with more hawkish projections. The updated Summary of Economic Projections indicated a higher terminal, or peak, policy rate of 5.1% for a longer period of time relative to market expectations, with no cuts anticipated until 2024. In his press conference, Fed Chair Jerome Powell noted that while recent inflation data is welcome, the Fed still needs to see substantial progress on this front before altering policy. He also dismissed China’s reopening as having a significant impact on US growth or inflation. Despite Powell’s pushback, markets continue to price in rate cuts in the back half of 2023 (FIGURE 2).
Fed Funds Rate December 2023 Futures Pricing (%)
Chart data 12/21–1/23. The federal funds rate is the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. Source: Bloomberg
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).
US Dollar/Japanese Yen Spot Exchange Rate
Chart data: 1/22–1/23. Source: Bloomberg.
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.
Japan has historically been the anchor of the global rates complex, so a substantial move could push rates higher globally.
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.
Chinese Precautionary Savings
Chart data: 1/17–9/22. Source: National Bureau of Statistics.
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).
Central-Bank Balance Sheets as a Percentage of GDP
Chart data: 1/99–12/22. Source: Bloomberg
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).
Net Private Saving: Households and Institutions
Consumer Debt Levels % Change Year-Over-Year
Chart data: 1/99–12/22. Source: Bloomberg
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.
Sectors in which we see opportunity (our views and positioning are dynamic and these may not change for months or may change intra-month depending on market conditions):
Fixed-Income Sector Excess Returns:
As of December 31, 2022. Past performance does not guarantee future results. Investors cannot invest directly in indices. Global Aggregate is represented by the Bloomberg Global Aggregate Index, a broad-based measure of the global investment-grade fixed-rate debt markets. Euro Aggregate is represented by the Bloomberg Global Aggregate Index - European Euro, which includes fixed-rate, investment-grade Euro denominated bonds. UK Aggregate: Bloomberg Global Aggregate Index - United Kingdom which includes fixed-rate, investment-grade sterling-denominated bonds. US Aggregate: Bloomberg US Aggregate Bond Index is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index. US Fixed MBS: Bloomberg Agency Fixed-Rate MBS Index tracks fixed-rate agency mortgage backed passthrough securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). US CMBS: Bloomberg CMBS ERISA Eligible Index, which measures the performance of investment-grade commercial mortgage-backed securities, which are classes of securities that represent interests in pools of commercial mortgages. The index includes only CMBS that are Employee Retirement Income Security Act of 1974. US ABS: Bloomberg Asset-Backed Securities Index, the ABS component of the Bloomberg US Aggregate Index, which has three subsectors: credit and charge cards, autos, and utility. US IG Corporates: Index Bloomberg US Corporate Investment Grade Bond Index covers all publicly issued, fixed rate, nonconvertible, investment-grade debt. US Corporates Aaa: Bloomberg Aaa Corporate Index; US Corporates Aa: Bloomberg Aa Corporate Index; US Corporates A: Bloomberg A Corporate Index; US Corporates Baa: Bloomberg Baa Corporate Index; US High-Yield Corporates: Bloomberg US Corporate High Yield Index is an unmanaged broad-based market-value-weighted index that tracks the total return performance of non-investment grade, fixed-rate, publicly placed, dollar denominated and nonconvertible debt registered with the Securities and Exchange Commission. Global IG Corporates: Bloomberg Global Credit - Corporate Index is an unmanaged index considered representative of fixed rate, non-investment grade debt of companies in the US, developed markets, and emerging markets. Emerging-Markets Debt: Bloomberg Emerging Markets Hard Currency Index includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Sources: Bloomberg, Wellington Management.
US Yields (%)
As of 12/31/22. Source: Bloomberg
Fixed-Income Spreads (Basis Points)
As of 12/31/22. A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed-income security. Source: Bloomberg, JP Morgan, Morningstar LSTA.
1 Yield curve is a line that plots interest rates of bonds having equal credit quality but differing maturity dates; its slope is used to forecast the state of the economy and interest-rate changes. In 2016, the BOJ enacted a strict yield-curve control policy that limited yields on Japan's 10-year Treasury bonds to 0.25%.
2 Core funds typically invest in a baseline of investment-grade bonds. Core plus funds take that baseline and add additional securities such as high-yield, global, or emerging-market debt to that core portfolio to enhance returns.
3 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.
4 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.
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Important Risks: Investing involves risk, including the possible loss of principal. •Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. •Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Mortgage-related and asset-backed securities’ risks include credit, interest-rate, prepayment, and extension risk. ● Loans can be difficult to value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets. • Diversification does not ensure a profit or protect against a loss in a declining market.
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