Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
21 April 2023
A (more) united view on duration
With volatility now back at pre-March levels, we examine the economic outlook for developed markets and our expectations for next month’s central bank meetings.
Fundamentals
With the US, UK and eurozone in the final stages of the economic cycle, investors are assessing how much longer central banks will be able to raise interest rates and tighten financial conditions. This assessment is closely linked to the differing progress being made to bring down inflation across regions. The market’s focus has shifted back to inflation, now that banking sector stresses have cooled. In the US, the latest consumer price index (CPI) release supported the view that inflation has come down steadily from its peak, with six-month annualised inflation declining from a high of 8% last June to 3.7% this March. The sticky shelter CPI component may also finally be starting to cool, while forward-looking measures of inflation and inflation expectations are pointing to downward pressure. This all stands in contrast to the UK, where the latest CPI print has surprised to the upside and remains in double-digit territory at 10.1% in March. Not just on a headline level but also after excluding the more volatile food and energy components, core inflation remains sticky for both goods and services as the UK faces further supply chain-related issues. The eurozone, meanwhile, sits somewhere in between the US and UK, with inflation yet to fall meaningfully and core inflation remaining sticky, although not reaching double-digit territory.
Quantitative valuations
As the acute banking stress has eased, terminal rates have repriced lower and are now back to levels last seen in January. The market’s central case is for the Federal Reserve (the Fed) to raise interest rates by another 25 basis points (bps) at the upcoming Federal Open Market Committee meeting on 3 May, and to then briefly pause before cutting interest rates in the second half of the year. Yields may therefore continue to grind higher in the near term. With the European Central Bank having started its tightening efforts later than the Fed, the market expects ~75bps in additional rate hikes to follow by October before rates are expected to come down towards the end of 2023. Interestingly, the pricing implies that US and eurozone terminal rates will gradually converge throughout 2024 and 2025. While the market paints a similar picture for the UK, with additional hikes being priced in before peaking at the end of this year, the terminal rate is expected to stay at an elevated level for longer compared to the US and the eurozone.
Developed market central bank terminal rates have repriced in the aftermath of the banking stress
Source: Bloomberg, J.P. Morgan Asset Management; data as of 19 April 2023. OIS = overnight index swap rate.
Technicals
Survey data indicates that many investors have now positioned for an end-of-cycle scenario, adding bonds to their portfolios and, within their bond allocations, adding duration. In fact, investors are overweighting bonds, both in absolute terms as well as relative to their equity allocations, to an extent last seen in March 2009 during the great financial crisis. Comparing sentiment to exposure data suggests investors remain positive on duration and have capacity to add more from here. From a volatility standpoint, the MOVE (Merrill Lynch Option Volatility Estimate) index has normalised and is back down to pre-banking stress levels – supporting the thesis that the market is inclined to agree on a more “united” view of what is to come for developed market economies and their bond markets.
What does this mean for fixed income investors?
After favouring a short duration positioning throughout 2022, investors have now shifted towards the very opposite end of the spectrum in anticipation of an end to the current cycle. Taking out risk and adding duration have been the key plays. We continue to closely monitor factors that may have an impact on developed market central banks, in terms of when they may conclude their tightening. From a strategic perspective, given our base case is that we are headed towards recession, we continue to favour duration.
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.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
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)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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