KBND - Central Banks Compelled To Hold Tight

2023-06-20 09:45:00 ET

Summary

• Sticky inflation is leading major central banks to keep policy tight. We prefer emerging market debt as policy loosens and like short-dated bonds for income.
• Developed market short-term bond yields jumped after central banks signaled more rate hikes to come. We see rates staying higher for longer.
• This week’s PMIs will help gauge how much rate hikes have cooled activity. We already see signs that a mild recession has unfolded in the U.S. and euro area.

Transcript

The outcome of last week’s major central bank decisions shows how persistent inflation, in a world shaped by supply, is forcing central banks to hold tight.

The central banks in Australia and Canada were forced to resume rate hikes after a short pause. That story has been compressed into a single meeting for the Fed, as it managed to convince markets hikes will immediately resume in the same meeting where it delivered a pause.

1) Fed de-emphasizing downside risks

The Fed raised its growth forecast for 2023 even as growth so far surprised to the downside. That seem to be predicated on the “robust” labor market.

But that is a shaky basis for a growth upgrade. The historical labor market cyclical linkage is already broken: for the first time, the unemployment rate reached historic lows even as activity has contracted.

2 ) Opportunities in emerging markets

Unlike the Fed, the European Central Bank hiked again last week.

This stands in contrast to emerging markets, where central banks were faster to hike and are now closer or at the point to cut rates - with China moving to prop up its slowing economy last week.

The new macro regime continues to play out in developed markets. That makes us lean into emerging market assets.

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Sticky inflation looks to compel developed market ((DM)) central banks to crank policy rates higher - and keep policy tight for longer. The Federal Reserve paused last week but pointed to more hikes on the way. The European Central Bank (ECB) raised rates and made clear it wasn’t done. Others hiked after earlier pauses. We prefer emerging market ((EM)) debt due to looser policy potential, like recent rate cuts in China. We also like income opportunities such as short-dated bonds.

Jobs-growth disconnect

Notes: The chart shows U.S. non-farm payrolls indexed around recession peaks as defined by the National Bureau of Economic Research. 2020 is excluded from the sample. The red line is indexed to Q3 2022 prior to the start of the contraction in the average of GDP and growth domestic income (GDI).

Labor shortages are fueling wage growth, keeping core inflation elevated. That has led the Fed to double down on a “whatever it takes” approach to fighting inflation: last week, it signaled more hikes in the same meeting where it paused. This is happening as central banks in Australia and Canada resumed hikes after attempted pauses - and as the ECB hiked again. We think the Fed and ECB appear to be underappreciating the existing damage from hikes. The Fed revised its growth forecast up based on historically low unemployment. The Fed may be relying on a job and growth relationship that has broken, in our view. Labor shortages have made firms reluctant to let workers go, even as demand slows and growth stagnates. That has made job growth look resilient (orange line in the chart) in recent months compared with weaker jobs data in past recessions (gray lines), even as some data suggest recession may have already arrived.

A broad measure of activity that in the past has been a good indicator suggests as much. The average of U.S. gross domestic income and GDP has contracted for two consecutive quarters. We think the Fed’s improved growth forecast ignores the sharp trade-off it faces: crush growth or live with inflation. We think it also exposes an important inconsistency: even higher rates to combat still-high inflation - but with a better growth outlook than previously expected. We don’t think the Fed can expect to bring inflation back down so quickly and maintain such an optimistic view on growth. CPI data last week confirmed core inflation is not cooling enough yet for inflation to return to 2%. We prefer short-term government bonds for income as interest rates stay higher for longer.

Pricing policy

This new regime of heightened macro and market volatility requires us to constantly assess what is being priced by markets. That helps uncover regional nuance in how markets are interpreting the macro story across DM. The ECB’s determination to keep hiking has pushed up euro area government bond yields. The market pricing of hikes by the ECB and the Bank of England has become more extreme than our view: pricing shows rates for both staying higher for much longer than the Fed, while inflation stays elevated. Recent wage data in the UK confirmed the worker shortage and supply constraints plaguing other DMs, but we don’t see the inflation problems there or in the euro area as fundamentally much worse than in the U.S. The market pricing in more rate hikes than we think likely is what led us to close our previous underweight on UK gilts in May. We find gilt yields more attractive after having risen near levels reached during 2022’s budget turmoil and prefer short-term maturities. We also like global inflation-linked bonds due to persistently higher inflation.

Emerging market contrast

The EM policy picture stands in sharp contrast with DM. EM central banks started hiking sooner, and we think their hiking cycles are closer to an end. That’s why we like EM local currency debt, especially in Brazil and Mexico. Falling inflation makes room for central banks in the emerging world to loosen monetary policy, we think. Case in point: China cut some policy rates just last week as its economic restart from pandemic lockdowns loses steam. Brazil’s central bank governor also hinted last week that the central bank could start cutting rates soon. The market has priced in cuts starting in August through year-end.

Bottom line

We think tight policy is likely here to stay as sticky inflation compels major central banks to keep policy tight - and likely tighten even further. We see more scope for policy easing in EM - that’s why we prefer EM local currency debt. We also like short-dated bonds for income against this backdrop. Read more in our 2023 mid-year outlook on June 28.

Market backdrop

Short-term bond yields jumped in the euro area and UK on market expectations for further rate hikes after the ECB’s signal and UK data showed surprisingly strong wages. Two-year Treasury yields also rose as the Fed signaled more rate hikes even after a pause. These events confirm the ongoing tightening bias of central banks facing sticky inflation. DM stocks hit new 14-month highs, with gains broadening beyond the mega-cap tech shares that have been the big winners this year.

Global manufacturing and services data will be in focus this week to gauge how much rate hikes have cooled activity. The U.S. has entered a mild recession based on an income measure. So has the euro area, after two consecutive quarters of contracting growth. We think central banks will keep rates higher for longer to fight stubborn inflation even as activity slows.

This post originally appeared on the iShares Market Insights.

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