Global Fixed Income Views Q2 2023
Themes and implications from the Global Fixed Income, Currency & Commodities Investment Quarterly
- Recession remains our base case, at 60% probability, with central banks saying they will fight inflation aggressively. We lowered Crisis to 5% and raised Sub Trend Growth to 35%, acknowledging the global economy’s resilience.
- The fastest monetary tightening since 1981 is hitting some parts of the economy but its wider impact is being cushioned by strong corporate financials, the catch-up in activity after the pandemic, China’s reopening and most of all, still-abundant savings sloshing around from excessive pandemic-era stimulus.
- The economy is at risk of the dreaded wage-price spiral. Markets have priced in further tightening, but how high could the Federal Reserve go? For now, we expect 25 basis point hikes until 5.5%; rates of 6% or higher are not implausible but would send risk markets plummeting.
- As we head into a contraction, adding high quality bonds in the front end of yield curves is our top idea, such as short-maturity investment grade corporate bonds and securitized credit. Emerging market local debt and agency mortgage-backed securities are other areas of opportunity.
What rate shock?
Our March Investment Quarterly (IQ) was held in New York in the aftermath of Federal Reserve (Fed) Chair Jerome Powell’s Congressional appearance. As markets tried to understand the persistence of surprisingly strong labor data and sticky inflation despite the Fed’s aggressive tightening, Powell gave unambiguously hawkish testimony. Perhaps, like us, he was frustrated that signs of the impact of tighter monetary policy were few and far between. Perhaps he was becoming impatient waiting for the long and variable effects of tighter monetary conditions to bite. Nonetheless, he opened the door to a re-acceleration to market-rattling 50 basis point (bps) rate hikes.
The group spent considerable time drilling into economic and market data, trying to understand the balance of risks. We see evidence that the fastest tightening of monetary conditions since 1981 is hitting in some places, specifically the interest rate sensitive parts of the economy. But very low unemployment, strong U.S. and European corporate financials, a recent reversal to higher inflation rates and still-abundant excess savings had us questioning whether the 450bps in rate hikes to date were enough of a shock to drive growth and inflation lower. If 450bps of hikes in less than 12 months is not sufficient, perhaps a 6%-plus fed funds rate is genuinely on the table.
There is clear evidence monetary policy is slowing housing markets, tightening lending conditions and depressing business investment, especially in more indebted countries. But labor markets have been surprisingly resilient, even allowing for lags. Apparently, the impact of tightening has been dampened by excess savings, and ongoing pandemic catchup in some sectors, which should fade over time. Further adding to global growth are the reopening of China and Europe avoiding a harsh winter. China’s reopening is adding to global consumption, while a warm European winter has given consumers extra discretionary income to spend.
Ultimately, for the central banks, it’s all about inflation. Can they make enough progress toward their 2% target to allow them to pause and take the pressure off markets? We think that loosening the labor markets is the key. If the Fed can bring wage gains down to 3.5%–4%, then core inflation should eventually come down to about 2.25%. But low levels of unemployment suggest that slowing wage gains may be very challenging. Of course, the easiest way to bring wages down is to increase unemployment, which substantially increases the risk of recession and a hard landing. For now, we see the Fed hiking rates in 25bps increments, until they reach 5.5%.
What was hard to process was that the most aggressive tightening cycle in decades has had seemingly little impact on growth and inflationary pressures. While the group understood that changes in monetary policy could take over a year to impact the real economy, we had expected to see more evidence by now.
We concluded that the excess monetary and fiscal stimulus from the pandemic era is still sloshing around in the system and cushioning the impact of Fed tightening. Excess savings seems to be the heart of the matter. Our proprietary Chase data shows that deposit balances are still above their pre-COVID-19 levels, even for people in the lower income brackets. Corporate America has stockpiled low-cost funding over the last several years and has prepared for an eventual recession. And a look at state and local government finances shows that rainy day funds are near record highs.
Apparently, excess savings are offsetting higher inflation and financing costs and allowing businesses and households to continue to spend. A tight labor market allows the consumer to continue demanding wage increases, thus affording—and validating—the higher price levels. This is exactly the wage-price spiral all central banks are trying to avoid.
Recession remains our base case and was kept unchanged at 60%. The central banks are in all-out inflation-fighting mode. Rates will go as high as necessary and ultimately trigger the painful adjustment we all hoped would be avoided.
We downshifted the probability of Crisis (to 5% from 10%) and raised Sub Trend Growth (to 35% from 30%) to acknowledge the resiliency of the global economy. Could it be that, as in 1995, a soft landing is still a possibility? It seems aspirational.
We left Above Trend Growth (0%) unchanged. Central banks are telling us that they will be merciless in bringing inflation down to their target, even at the expense of the economy.
The primary risk to our forecast is that if the central banks are unable to bring inflation meaningfully lower, they may become impatient waiting for the cumulative and lagged impact of monetary tightening to hit, and keep raising rates well above market expectations. By the time they stop, the policy effects would have hit hard, and a significant recession would ensue.
While the markets have priced in a lot of rate hikes, a Fed that goes to 6% or higher and a European Central Bank that goes to 4% or higher would be shocks that would likely cause asset prices to plummet. Seem implausible? There are still upside inflation risks if the China reopening continues to accelerate and/or the Russia-Ukraine war has a renewed impact on the cost of energy and agricultural products.
Buying high quality duration in the front end of yield curves was the top idea coming out of our meeting. Two-year U.S. Treasuries at 5%, and fed fund futures at 5.625%, are pricing in a lot of further tightening and creating considerable carry for short-maturity securities. Adding investment grade corporates and securitized credit can bring front end yields up to 6%–7%, a level where it would be very hard to generate a negative return over the balance of the year.
Emerging market (EM) debt also garnered a lot of interest. Aggressive EM central bank tightening starting in early 2021 has been impressive and there are now very high real yields to be had in those markets. Further, a peaking U.S. dollar would add a nice FX tailwind to local EM debt.
Lastly, agency mortgage-backed securities look cheap. After a year of torture from negative convexity (notably, duration extension), the absence of bank buying and the removal of Fed support, the market looks washed out. A government bond with yield should be the ideal investment headed into a contraction.
In the journey from Fed rate hikes to the ultimate recession, the economy passes through a period that looks like a soft landing—it has every time before. Since 1981, the average time from the last rate hike until recession has averaged 13 months. This suggests that a Fed pause in Q2 2023 might not trigger a recession until the middle of 2024. During that waiting period, the soft landing camp, the recession camp and the hard landing camp can all claim they are correct. For us, the Fed’s war on inflation means recession, and a greater rate shock, are in the offing. We’re ensuring that our portfolios are prepared.
Scenario probabilities and investment implications: 2Q 2023
Every quarter, lead portfolio managers and sector specialists from across J.P. Morgan’s Global Fixed Income, Currency & Commodities platform gather to formulate our consensus view on the near-term course (next three to six months) of the fixed income markets.
In day-long discussions, we reviewed the macroeconomic environment and sector-by-sector analyses based on three key research inputs: fundamentals, quantitative valuations, and supply and demand technicals (FQTs). The table below summarizes our outlook over a range of potential scenarios, our assessment of the likelihood of each, and their broad macro, financial and market implications.
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