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05 May 2023
The central bank hiking race
Central banks around the world have been tightening monetary policy throughout 2022 and into 2023 but when will they be finished? And when they do get over the line, what happens next?
Fundamentals
Following its latest 25 basis point hike, we believe that the Federal Reserve (Fed) has now reached the finish line in hiking policy rates. Inflation has started to fall and there are signs of economic instability which should allow the Fed to pause and take a breather from tightening monetary policy. Over previous hiking cycles, the Fed may have claimed poll position in being the first central bank to finish hiking policy rates, however over this cycle the victory belongs to emerging market central banks who hiked rates early and aggressively in 2021 and into 2022. Conversely other developed market central banks are lagging behind as they continue to grapple with inflation. The European Central Bank (ECB) and Bank of England are still on the final lap of increasing policy rates while the Reserve Bank of Australia misjudged the finish line entirely and has now set off hiking rates again. As central banks reflect on the impact of the hiking race, a question of how to approach the next race of cutting policy rates begins. But when the starting gun for this race fires remains uncertain. For the US, an escalation of the regional banking crisis and any knock-on impact to the economy and labour market would lead to an early start, as could any disorderly outcome to the debt ceiling negotiations. However, if robust economic data persists, then the Fed may be able to catch its breath until nearer the end of the year.
Quantitative valuations
While all central banks have been running a hiking rates race, their respective finish lines are not exactly the same. Current market pricing of implied levels of interest rates expect the Fed to stop hiking rates at 5-5.25% in the summer, whereas the ECB is expected to be finished at 3.5%. In emerging markets such as Brazil and Mexico, policy rates are much higher at 13.75% and 11% respectively. Current market pricing for the race to cut rates is expected to start later in 2023 and continue into 2024. The standings in the cutting race also appear to be similar to that of the hiking race with some emerging market central banks cutting first, followed by the Fed and then other developed market central banks in last place.
Future central bank pricing (%)
Source: Bloomberg, J.P. Morgan Asset Management as of 4 May 2023.
Technicals
For now, as central banks race towards the finish line of hiking rates, investors are extending duration in their portfolios. This can be seen in proprietary J.P. Morgan Asset Management positioning surveys which show that as the markets approaches the peak of policy rates, investors seek to lock in these higher level of yields before central banks start the next race of lowering policy rates. With a recession on the horizon, we find that investors are also allocating capital to safer parts of the fixed income universe such as USD government funds, with inflows of +7.1% of total AUM in 2023, along with EUR government funds with inflows of +4.4%. These inflows are coming at the expense of riskier sectors such as USD loan funds -15.5% and USD high yield funds -3.5%, which would be expected to underperform in a recessionary market environment.
What does this mean for fixed income investors?
Within fixed income portfolios, we have a preference for the bonds of central banks that have finished the hiking race such as emerging market local currency bonds and high-quality bonds in the US. In these markets we are extending duration in order to capture these higher rates. In the eurozone, we are scaling into longer duration over time as the ECB approaches the finish line. Central banks are typically able to start the cutting race before their economies officially enter a recession and as such, we remain vigilant on leading market indicators such as the labour market in order to appropriately manage the risks of active positioning.
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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