With high levels of inflation persisting around the world, central banks must tighten policy without hurting consumer demand and economic growth. This will be more difficult for some central banks than others, says Sunil Krishnan.
Read this article to understand:
- Why the US Federal Reserve and the Bank of Japan have more room to tighten than others
- The difficult balancing act facing the European Central Bank and the Bank of England
- What this means for government bonds
After a dramatic first quarter 2022 sell-off in US Treasuries, the bond markets we feel most comfortable being underweight are Japan and the US. They have more room for manoeuvre to raise interest rates than Europe or the UK, while emerging market bonds remain more of a risk asset than a safe haven.
US Treasuries
First-quarter losses in the US Treasury market were dramatic, implying a rise in yields worse than in any individual quarter in the 1970s.
Figure 1: US Treasury yields since 1973 (per cent)
Past performance is not a reliable indicator of future performance. For illustrative purposes only, not intended as an investment recommendation.
Source: Bloomberg. Data as of May 18, 2022
That is also reflected in market pricing, which shows the Federal Reserve (Fed) repeating the 50 basis points (bps) May hike at its next three meetings; this would translate to yields of around three per cent by January 2023.
Such a response makes sense because we see the US economy as reasonably resilient, with some capacity to absorb higher rates. Households have large cash positions built on the stimulus cheques they received during the pandemic and, through long-dated fixed mortgage rates, their sensitivity to interest rate rises is lower than in markets like the UK or Australia. Meanwhile, companies have been active issuing in the bond markets over the last 15 years, but have largely spent that time extending their debt maturity profiles.
However, the market is pricing in a peak in the Fed funds rate of 3.25 to 3.5 per cent at some point in 2023 and even some cuts at the very end of 2023 and into 2024. In contrast, we think rates may have further to climb if inflationary pressures remain and growth is resilient. For instance, if rates peak at 3.5 per cent and inflation doesn’t converge neatly back to target but settles around three per cent, the real interest rate will only be half a percent – against the backdrop of an economy that, in real terms, could be growing by more than two per cent.
Therefore, given the current market pricing for rate expectations, the risks continue to lie to the upside. With that in mind, we see the US Treasury market as a core underweight.
The risks continue to lie to the upside
Of course, there may be noise. Investors have recently started to consider the possibility of recession, for example, but we don't expect such expectations to last. First-quarter US GDP growth was negative. However, that was heavily driven by the scale of imports and a relative drop in inventory rebuilding – which was in fact extremely strong, just not quite as strong as the reopening-led growth in the previous quarter.
Meanwhile, the pace of consumption and investment remains robust. And the biggest inflation pressures are in demand-sensitive areas like labour and housing; in this sense, inflation is an indicator of the strength of demand, not a threat to its continuation. There is little evidence to support concerns that the cost of living in the US will feed through into lower spending.
It is different in other parts of the world, like the EU and UK, where inflation is driven by energy prices, creating a risk consumer demand could fall but prices remain high.
European rates
The European Central Bank’s (ECB) balancing act is harder than the Fed’s because the headline inflation numbers are similar but heavily driven by commodity prices, with less widespread wage or housing price rises.
The causes of sharply rising energy and food prices are as much to do with issues for producers and supply chains, which economists like to call supply shocks, as they are to do with demand shocks. As such, the possibility of a cost-of-living crisis seems much more plausible in Europe. Supply shocks are difficult for central banks to deal with because they pose a downside threat to growth at the same time as adding to inflationary pressure.
The real question is whether growth will be strong enough to allow for monetary tightening
The real question, with Europe so close to the epicentre of the Ukraine war, is whether growth will be strong enough to allow for monetary tightening. ECB governor Isabel Schnabel recently talked of ending bond purchases and starting to raise rates in June or July 2022, but the central bank is undoubtedly aware there may be a period of weak GDP growth, and competing national perspectives mean it cannot speak with one voice yet. It will be hard for it to go full steam ahead, notwithstanding the inflation problem.
We share the current market view that the ECB will probably start tightening measures this summer, and perhaps bring rates back into positive territory by the end of the year. This is a more cautious stance than the Fed’s but could nonetheless cause a seismic shift because European capital markets and economic activity have relied on extremely low – and even negative – interest rates for so long. Exactly what will happen as a result of that change in policy remains to be seen.
Figure 2: European corporates have relied on low interest rates (per cent)
Past performance is not a reliable indicator of future performance. For illustrative purposes only, not intended as an investment recommendation.
Source: Bloomberg. Data as of May 18, 2022
UK gilts
The Bank of England (BoE) faces a similar supply shock and cost-of-living issue to the ECB. If anything, it is more acute, because the UK imposes less explicit policy caps on utility prices than a country like France, meaning energy prices could have more of a slowing effect on consumer demand. At the same time, inflation is clearly out of the Bank of England's comfort zone.
The UK could be an important test case to understand at what stage monetary policy starts to bite
The difference with the ECB is that the BoE is starting its tightening earlier, so there is a greater risk it reaches the stall point for the economy quicker than other central banks. The US is starting earlier but has a higher potential ceiling, and the ECB has some of the same supply shock challenges but is starting later. The UK could therefore be an important test case to understand at what stage monetary policy starts to bite.
This growth challenge and early rate rises are reflected in the outperformance of the gilt market relative to others so far in 2022.
Figure 3: UK gilt market outperformance
Past performance is not a reliable indicator of future performance. For illustrative purposes only, not intended as an investment recommendation.
Source: Bloomberg. Data as of May 18, 2022
The UK is also the most obvious market where participants have priced in an outright peak in interest rate expectations, even more so than in the US. Interest rates are priced to peak in the summer of 2023 and be 35 to 40bps lower than this high by the end of 2024.
Figure 4: UK interest rate expectations
Past performance is not a reliable indicator of future performance. For illustrative purposes only, not intended as an investment recommendation.
Source: Bloomberg. Data as of May 18, 2022
The cuts may be larger by then, but there is a more explicit discussion in the UK about a peak being followed by a cutting cycle than in most of the other major economies.
As the Fed and BoE embark on tightening cycles, we could see gilts continuing to outperform US Treasuries, reflecting the difference in economic strength between the countries.
Japanese government bonds
Japan is another country where parts of the economy are reliant on commodity imports, and this also comes at a time of weakness in the currency. On May 4, the yen was at 130 to the dollar, having started March at 115, a significant move that could exacerbate the cost pressures coming from commodity prices.1
This also enters the realm of a supply shock, the difference being that Japan has fewer imminent growth challenges than Europe or the UK. Its outlook for the year is a post-COVID-19 reopening, and rising prices may bring benefits in areas such as real estate, which have suffered from years of deflation.
It is simpler for the Bank of Japan to plan its exit from stimulus
For those reasons, it is simpler for the Bank of Japan (BoJ) to plan its exit from stimulus. It will want to do so in an orderly manner. For instance, it would not want to be forced into policy changes to arrest accelerated declines in the yen. But at 130 to the dollar, the yen is not at a level where the central bank is forced to act. For now, the BoJ is therefore credible in aiming to maintain its ten-year government bond yields below 0.25 per cent.
The question is how and when it might choose to act if its governors feel attempts to allow inflation into the economy have been successful and risk becoming too successful. While we estimate the downside risk to ten-year yields as limited by the yield target policy, if the BoJ decides to start adjusting later in 2022, the upside risk could be substantial. It wouldn't be a stretch to see a 50bps rise in yields in such a scenario. The risk is currently quite asymmetric, so we see underweights as an inexpensive option on a change in policy.
In addition, Japanese investors are big players in overseas bond markets. The potential for substantial rises in Japanese government bond yields could prompt a repatriation of Japanese capital and disrupt other markets, potentially driving US Treasury or European government bond yields higher. Having an exposure to rising rates in Japan potentially can offer some protection against this slightly esoteric risk.
Emerging markets
Currently, we are broadly neutral on emerging market bonds despite inflation and rising US Treasury yields, partly because central banks in emerging markets have moved fast to try and get ahead of inflation. On May 4, we saw a surprise hike in India, while over recent quarters countries like Poland and Brazil took a more hawkish stance than expected.
Emerging markets should be thought of as more growth-type assets than safe havens
These countries are probably closer to the end than the beginning of the cycle of rate hikes, leaving the bonds with a strong carry profile in terms of excess returns over and above short-term rates, but also compared to major currencies when adjusting for volatility.
This is quite different from the slower pace of developed market central banks. For that reason, emerging markets should be thought of as more growth-type assets than safe havens.
