Analyses
Is Monetary Policy Angst Overdone?
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Global Fixed Income Bulletin
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novembre 15, 2021
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Is Monetary Policy Angst Overdone?
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novembre 15, 2021
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Is Monetary Policy Angst Overdone?
Is Monetary Policy Angst Overdone? |
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A key question hanging over financial markets is: how hard will central banks push back against inflation? Inflation has continually surprised to the upside, even if it is no longer surging higher in year-on-year terms. Developed market central banks had until recently remained calm, accepting that most of the shock was likely transitory due to supply chain and labor market disruptions, and large shifts in aggregate demand to goods from services. Being unusually sanguine, they talked dovishly, remained focused on downside risks and hoped it would sort itself out before transitory morphed into troubling.
No more. Bond markets, but surprisingly not equity markets, were rocked in October by hawkish shifts in central bank policy and rhetoric and aggressive repricing of rate expectations. The era of central bank passivity has come to a close, and policy normalization has begun. First the Norwegian central bank raised rates in September. Removing accommodation no longer needed was the justification. Then two weeks later the New Zealand central bank in early October raised rates, in a more hawkish fashion, meaning this was the first of potentially many rate hikes. The initial view was they’re small countries and markets did not think they mattered too much. But then the Bank of Canada on October 27th suddenly, seemingly out of the blue, ended quantitative easing (QE) and announced rates would likely be hiked mid-2022, almost a year sooner than expected. This was compounded by credible talk from the Bank of England that they would raise rates in November, and the Australian central bank failed to defend their yield curve control policy, sending yields up 62 basis points (bps) in three days! In a country where the central bank has adamantly insisted rates would not rise at all until 2024! Of course, it did not help that the Fed was meeting in the first week of November where they were highly likely to confirm (which they did) ending their emergency QE programs, which sent U.S. short-maturity yields significantly higher.
What to make of all this? Normalization is the new mantra. The need for emergency levels of accommodation are broadly thought to be no longer necessary, especially with growth above trend in 2021/22 and inflation proving to be potentially more than transitory. However, normalization is not tightening. It is removing unnecessary accommodation and getting policy back to a more neutral setting. As such, for most countries, like the UK, Eurozone, Canada, and most importantly the U.S., we should not expect their central banks to tighten policy aggressively; they are more likely to take a more leisurely approach to policy adjustments than the market currently expects. In the case of Australia, if the Reserve Bank is any good at forecasting its own policy, interest rates have well overshot. Emerging markets (EM) are another story with significant hikes occurring and no end in sight as inflation has become even more intransigent in countries like Poland, Czech, Russia, Mexico and Brazil. As such EM local markets have had a horrid time as monetary policy tightenings have been big and unrelenting (and as of yet no letup in inflation pressures).
Therefore, we expect DM central banks to proceed slowly and with caution, and yes monetary policy angst is overdone. But this could still lead to volatility in markets, depending on what investors expect. Markets initially aggressively priced the beginning of rate hiking cycles, much more than most central banks thought appropriate. Indeed, the most egregious sell offs in front ends of yield curves are already correcting themselves. We expect the total amount of tightening to remain modest as, again, most developed market central banks do not want restrictive policies: they simply want less accommodative policies. However, if investors (or central banks) change their mind on this, for example because higher inflation appears to become more entrenched and the economy remains resilient, bond yields might need to rise considerably. In credit markets, spreads are still below long-term averages despite recent volatility; this seems justified given the benign economic outlook and stronger corporate and household balance sheets, but even a minor deterioration in credit conditions could impact valuations. Of course, the “central bank put” could still come into play, with tightening measures delayed or cancelled if markets wobble too much, but the pace of normalization will primarily depend on the state of the economy.
In terms of our market views, we have generally been reducing portfolio risk given the uncertain outlook. We remain long risky assets (corporate credit, securitized credit, emerging markets) because of the positive economic outlook and strong fundamentals, and in spite of credit spreads being tight relative to history. We expect government bond yields to drift higher as we move towards tighter monetary policy, but it will be a “long and winding road”.
Note: USD-based performance. Source: Bloomberg. Data as of October 31, 2021. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions
Note: USD-based performance. Source: Bloomberg. Data as of October 31, 2021. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of October 31, 2021.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of October 31, 2021.
Source: Bloomberg, JPMorgan. Data as of October 31, 2021.
Source: Bloomberg, JPMorgan. Data as of October 31, 2021.
Fixed Income Outlook
October was an extraordinary month in terms of bond market volatility. While longer-maturity yields remained well anchored, short-maturity yields skyrocketed as central banks began to reduce accommodation. Through the first half of the month, longer-maturity yields generally rose as anxiety rose about inflation.1 Transitory was not turning out to be so transitory, and even if transitory, it had risen so high that, even if it came down substantially, it would still be too high for policymaker’s comfort at the end of 2022. Moreover, economic data was generally underperforming, whether it be labor markets, industrial production or consumption. While a lot of this uncomfortable mix could be blamed on supply side woes, it still put central banks in an uncomfortable position which troubled investors.
Starting in September, central banks in Norway, New Zealand, the UK, Canada, and Australia all did or said things which unnerved bond markets. With the Fed announcing the end of its QE program next year, and the ECB expected to do so in December, markets had additional reasons to worry. If central banks tightened global liquidity conditions too quickly, it could undercut the economy and make the current slowdown in growth (mostly supply side driven) worse, undermining risky assets such as high yield and equities while helping long maturity risk free bonds.
Short maturity bond yields shot higher over the last week of October and early November. Significant increases in official rates were forecasted in many countries. For example, over the next 12 months, markets expect central banks to hike rates in New Zealand (180 bps); Norway (100 bps); Canada (120 bps); UK (90 bps); Australia (80 bps); U.S. (45 bps); ECB (10 bps). These numbers have come down from their peaks a week ago but still look uniformly high; not impossible, just improbable. And remember that, for example, the RBA has emphasized it has no intention of raising rates until at least the second half of 2023! A long way off. It is also hard to believe that the industrial world can hike rates by this much if the Fed and ECB remain on the dovish end of the spectrum. Indeed, these predictions are higher than the respective central banks are predicting. In particular, the Fed continues to emphasize they have not achieved their labor market goals and will not hike at all until labor markets tighten further as measured by a combination of employment, unemployment rate, participation rates and inclusiveness. If the Fed and the ECB execute according to their forecasts it is very unlikely the other central banks will be able to pull away from the Fed/ECB/BoJ peloton.
Thus, we believe the market overreacted to central bank actions and we do not believe in the stagflation narrative. Growth is likely to rebound in Q4 (Eurozone has its supply side and COVID issues) and inflation is likely to stay high if not go higher still. October Purchasing Managers' Index (PMIs) showed a strong post-delta wave recovery in services with supply disruptions continuing to hold back manufacturing. Asia is doing better, and the latest U.S. employment report was quite positive although supply issues continue to hold down the participation rate. Moreover, global household savings remain elevated and financial conditions are easy and will remain easy even if there is modest central bank tightening whether through tapering or elimination of QE or actual rate hikes.
This relative sanguine monetary policy outlook is not without risk. Inflationary pressures are not abating or at least not fast enough. Worries about second round effects and surging housing markets worry central banks. The most recent surge has come from higher energy prices (especially European natural gas prices), but the pressure is more broad-based: many other commodities (e.g., food, a particular concern for EM central banks) are also at multi-year highs; COVID-induced bottlenecks continue to cause shortages in many consumer goods supply chains, and there are widespread reports of labor shortages across developed economies. It is currently unclear just how persistent, or permanent, many of these issues are, but what is certain is that the current surge in inflation is expected to last longer than previously thought, with economists now forecasting it will only return to more normal levels towards second half of 2022. Thus, the need for central banks to play defense, engage in risk mitigation strategies which imply reduced accommodation.
Going forward we expect central banks to move slowly and deliberately, look through high headline inflation, and avoid doing anything to suggest policy needs to be “tight” rather than just less easy. But, with all central banks thinking along the same lines (to varying degrees), it is easy for individual central banks to hike rates under cover of the central bank “peloton.” As long as no one gets too far out in front, it will be easier for the global central banking community to collectively move rates higher.
Currently, markets expect a quick hiking cycle to lower than historic peak rates. The risk to bond valuations comes more from the length of the hiking cycle and the eventual terminal policy rate not as much about the pace (although that matters for the shape of the curve). But if the market starts expecting a more normal central bank cycle, then yields could rise further. Credit investors have also become more nervous recently, causing credit spreads to widen; we think this is mainly reflective of how tight spreads had become rather than any meaningful increase in default risk or deteriorating fundamentals.
Where does this leave our views on markets? In general, we remain overweight the riskier, cyclical sectors but we have been reducing risk at the margin given valuations and increased volatility/uncertainty. On government bonds, we expect yields to drift higher at the longer end of yield curves, but this is likely to be a long laborious process given high global liquidity/savings and a likely slow tightening cycle. That said, low expected terminal rates and highly negative real yields make longer-maturity bonds relatively unappealing. Shorter maturity bonds are more interesting due to much higher risk premiums now priced in. We remain overweight corporate and securitized credit, particularly lower quality investment grade bonds and selective high yield and are overweight in selective emerging markets (like Egypt and Dominican Republic), where there are, in our view, idiosyncratic reasons to be bullish.
Developed Market (DM) Rate/Foreign Currency (FX)
Monthly Review
Government bond yields rose modestly as inflation expectations continued to rise. Given growth also remains above average, central banks are increasingly moving towards reducing monetary accommodation. Markets began to price in a more aggressive timeline for policy tightening across the developed markets, but long dated government bonds remain rich vs. history.2
Outlook
The combination of above average growth and elevated inflation is likely to cause central banks to move towards tightening. While much of the increase in inflation is expected to be transitory, it has already proven to be more persistent than expected and the risks are skewed towards it staying higher for longer. This is likely to put upward pressure on government bond yields, especially given rich valuations. However, we also think markets have priced in too much central bank tightening in the short term.
Emerging Market (EM) Rate/FX
Monthly Review
EM debt returns were negative in October. Hard currency was flat. EM Corporates returns were negative for the month, with high yield underperforming investment grade corporates. Local currency bonds posted negative returns, primarily due to higher yields.3 Suriname, Sri Lanka, Belize and El Salvador were the best performers in October, while bonds from Lebanon, Argentina and Ethiopia were laggards. From a sectoral perspective, Metals & Mining and TMT companies led the market, while those in the Real Estate, Pulp & Paper and Consumer sectors lagged.4
Outlook
We have a cautious stance towards Emerging Market debt, as the asset class continues to face multiple disruptive forces, despite valuations being generally attractive. We favor a subset of EM High Yield credits featuring positive idiosyncratic stories, relatively solid fiscal stances, and/or exposed to higher oil prices (similarly, in EMFX). In rates, we prefer yield curves that are already pricing in aggressive monetary policy tightening.
Credit
Monthly Review
Credit spreads over the month were a touch wider through the month. Sector and corporate news in the month was dominated by Q3 reporting where the banks outperformed supported by non-performing loan provision write backs and non-financials focused on the impact of higher cost inflation with the majority exceeding expectations reduced in late summer citing pricing power to pass on cost increases. M&A remained a topic of continued speculation supported by low costs of debt. Global convertibles performed in between equity and credit in October as the Refinitv Global Convertibles Focus Index rose compared to MSCI Global equities and the Barclays Global Credit index.
Outlook
We see credit as fully valued but likely to consolidate at current levels supported by (1) financial conditions remaining easy, supporting low default rates (2) economic activity that continues to rebound as vaccinations allow economies to re-open (3) strong corporate profitability with conservative balance sheet management as overall uncertainty remains high; and (4) demand for credit to stay strong as excess liquidity looks to be invested. We expect good ability to earn attractive carry but see limited opportunities for capital gains from spread tightening.
Securitized Products
Monthly Review
Securitized markets were choppy in October. Performance seemed to be more a function of liquidity and depth of sponsorship rather than specific credit concerns. New issuance remained high and secondary trading increased materially in October while sectors with historically lighter sponsorship seemed to buckle under supply pressure.[5] Agency MBS performed very well in October, especially considering the curve flattening and upcoming Fed taper expectations.6 U.S. Non-agency RMBS spreads had very mixed performances while U.S. CMBS spreads widened in October.7 U.S. ABS spreads were mixed as well in October, with consumer and auto loans performing well, while spreads in less liquid sections such as mortgage servicing rights and aircraft ABS widened.8 European RMBS, CMBS and ABS activity remained high in October and European spreads remained steady.9
Outlook
We expect market activity to begin to slow in November. Higher rates, wider spreads and approaching year-end could cool overall activity levels. Credit fundamentals should remain very solid, especially for residential and consumer assets. European securitized markets should remain well supported by the historically low rates in Europe and by the asset purchase programs and lending programs of the ECB and BOE.
RISK CONSIDERATIONS
Diversification neither assures a profit nor guarantees against loss in a declining market.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.