Central Banks Compelled To Hold Tight

A broad measure of activity that in the past has been a good indicator suggests as much. The average 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 of 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.

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.

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 the 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 midyear outlook on June 28.

Market backdrop

Short-term bond yields jumped in the euro area and the 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.

Macro Take

Last week, data showed U.S. core inflation running hot at 5.3% year-on-year in May, as most expected. The surprise? A deeper look shows core goods prices – excluding food and energy prices – have accelerated. See the chart.

We expected goods inflation to keep falling this year, as the surge in U.S. consumer spending towards goods during the pandemic unwound. But it hasn’t been smooth. Core goods prices fell sharply at the end of last year but have rebounded – driven by things like used car prices.

Core services inflation excluding shelter costs is stubbornly high. It reflects wage pressures, especially in contact-intensive service sectors, as firms deal with labor shortages.

Sticky inflation reinforces why the Fed will keep rates higher for longer. We expect inflation to stay high into next year – leaving central banks with no room to cut rates. That’s even if activity weakens as the impact of this year’s rate hikes kicks in.

Investment themes

1 Pricing in the damage

• Recession is foretold as central banks try to bring inflation back down to policy targets. It’s the opposite of past recessions: Rate cuts are not on the way to help support risk assets, in our view.
• That’s why the old playbook of simply “buying the dip” doesn’t apply in this regime of sharper trade-offs and greater macro volatility. The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price.
• In the U.S., it’s now evident in the financial cracks emerging from higher interest rates on top of rate-sensitive sectors. Higher mortgage rates have hurt sales of new homes. We also see other warning signs, such as deteriorating CEO confidence, delayed capital spending plans, and consumers’ depleting savings.
• The ultimate economic damage depends on how far central banks go to get inflation down. The Federal Reserve paused rates in June but signaled further hikes ahead. The European Central Bank hiked again in June. We see the ECB going full steam ahead with rate hikes to get inflation to target – regardless of the damage that entails.
• Investment implication: We’re tactically underweight DM equities. They’re not pricing the recession we see ahead.

2 Rethinking bonds

• Fixed income finally offers “income” after yields surged globally. This has boosted the allure of bonds after investors were starving for yield for years. We take a granular investment approach to capitalize on this, rather than taking broad, aggregate exposures.
• Short-term government bonds look more attractive for income at current yields, and we like their ability to preserve capital. Tighter credit and financial conditions reduce the appeal of credit.
• In the old playbook, long-term government bonds would be part of the package as they historically have shielded portfolios from recession. Not this time, we think. The negative correlation between stock and bond returns has already flipped, meaning they can both go down at the same time. Why? Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation to policy targets. If anything, policy rates may stay higher for longer than the market is expecting. Investors also will increasingly ask for more compensation to hold long-term government bonds – or term premiums – amid high debt levels, rising supply, and higher inflation.
• Investment implication: We prefer short-term government bonds over long-term government bonds.

3 Living with inflation

• High inflation has sparked cost-of-living crises, putting pressure on central banks to tame inflation with whatever it takes. Yet there has been little debate about the damage to growth and jobs. We think the “politics of inflation” narrative is on the cusp of changing. The Fed’s rapid rate hikes will stop without inflation being back on track to return fully to 2% targets, in our view. We think we are going to be living with inflation. We do see inflation cooling as spending patterns normalize and energy prices relent – but we see it persisting above policy targets in coming years.
• Beyond Covid-related supply disruptions, we see three long-term constraints keeping the new regime in place and inflation above pre-pandemic levels: aging populations, geopolitical fragmentation, and the transition to a lower carbon world.
• Investment implication: We’re overweight inflation-linked bonds on a tactical and strategic horizon.

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