17 March 2023
Rate hikes – A fork in the road
Ongoing inflationary pressure, combined with the recent challenges in the US regional banking system, poses a rate-hiking dilemma for policymakers.
The US Federal Reserve (Fed) has reached a fork in the road. Over the last year, the central bank has increased its benchmark policy rate by 450 basis points (bps). This historically aggressive pace of hiking, combined with holding a greater amount of securities vs. loans, has placed the US regional banking system under significant strain and has contributed to the demise of three banks in the last two weeks. The Fed could justify a pause in its rate-hiking cycle, citing financial stability concerns, however, inflation remains an issue. The latest print shows that inflation was 6% year-on-year in February, with components such as shelter, transportation services and food prices driving much of the increase. Core Consumer Price Index (CPI) ticked up to 0.5% month-on-month, exceeding expectations that it would remain unchanged at 0.4%. The possibility of sticky inflation poses a challenge for the Fed, which will have to carefully weigh the need for financial market stability against continued inflationary pressure. Looking beyond March, the latest bout of market volatility means that the Fed will likely reconsider its hiking cycle for its May and June meetings to assess the strain on the banking system. We expect that this will lead to a lower terminal rate for the Fed funds rate than previously expected.
Investors have significantly repriced US interest rate expectations
On 13 March 2023, the two-year Treasury yield fell 62bps to 3.96%, its biggest single-day drop since 1987, as investors sought the safety of government debt while simultaneously repricing the pathway for interest rates in the immediate future. While underlying government bond yields have swung violently, corporate spreads have remained relatively well anchored. The option-adjusted spread (OAS) on the Bloomberg Global Aggregate - Corporate Index rose from 136 bps on 8 March to 157 bps on 14 March, slightly above the 10-year average of 152 bps. The relatively modest increase in OAS reflects the strength of corporate balance sheets particularly among the largest banks and industrial sectors. However, investors should remain cautious; corporate spreads do not typically peak until the economy enters recession, and the ongoing concerns about banking sector stability may see spreads widen further.
The technical picture suggests investors have moved to a risk-off position as the latest bout of financial market volatility has prompted investors to seek safe-haven assets. This is reflected in the net inflows into money market funds and US Treasury markets over the last three weeks. The latest moves coincide with the continued reduction in bond purchasing by central banks, as they continue to shrink their balance sheets. The aggregate of portfolio positioning survey data, calculated by J.P Morgan Asset Management, suggests that the escalating financial market volatility has seen investors seek the safety of long-dated Treasuries to protect against swings in riskier assets, with duration positioning in portfolios now moving one standard deviation above the long-run average.
What does this mean for fixed income investors?
The Fed will likely pursue a more cautious approach over the coming weeks and months as it tries to maintain financial market stability while inflation is still above target. As the Fed continues to balance financial market stability and its inflation target, investors should focus on higher-quality areas of the fixed income markets and continue to stress test their portfolios to ensure they are well prepared for a higher-rate environment.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum