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.
3 February 2023
Revisiting US duration
Slowing inflation in the US, particularly signs of slower wage growth, underpinned the recent smaller interest rate increase from the Federal Reserve. We explore the possibility that the US rate-hiking cycle could be coming to an end and what that means for fixed income positioning.
Fundamentals
Market consensus that US inflation has rolled over and will likely continue to decline has been a key driver of bond returns so far this year. The market’s attention has now shifted to the US Employment Cost Index (ECI), the broadest measure of labour costs, which is showing tentative signs that wage growth – although typically a sticker component of inflation – is slowing down. In 4Q 2022, US labour costs rose by 1%, the smallest increase since 4Q 2021 (as of 31 January 2022). Slowing wage growth and the recent material slowdown in house price growth indicate that the aggressive hiking policy of the US Federal Reserve (the Fed) is working and could potentially slow the pace of monetary policy tightening in the coming months. Already, the Fed increased the interest rate by just 25 basis points (bps) on 1 February 2023, in contrast to the December hike of 50 bps. However, further decreases in US ECI and a material weakness in the labour market may boost the Fed’s confidence that it can stop raising rates later this year, providing investors with an opportunity to add US duration.
Quantitative valuations
The slowdown in inflation has been a strong driver of Treasury returns in 2023. US 10-year Treasury yields declined 35 bps in January, ending the month at 3.53%, which translated into robust returns. After declining 12.46% in 2022, the Bloomberg US Treasury Index returned 2.51% in January 2023. Acknowledging these strong returns, we still believe valuations support structurally long US duration positioning in portfolios. With the Fed nearing its target terminal rate of 5.1%, the market is already pricing in 50 bps of rate cuts in the second half of 2023 (as of 2 February 2022), despite the Fed pushing back against this expectation. Any significant weakness in the labour market or increase in recession risks could force the Fed to pivot sooner rather than later, providing an attractive backdrop for US duration.
Technicals
Bond demand has picked up significantly in 2023. Four-week rolling high-frequency bond demand, which includes retail flows, overseas flows, Fed custody holdings and bank holdings of bonds, was $15.7 billion on 25 January 2023, up from -$18 billion on 28 December 2022. January 2023 was the first month of positive bond demand since August 2022. We expect this trend to continue as valuations still look attractive and the risk of recession remains. A further increase in demand could cap any potential uptick in US government bond yields.
What does this mean for fixed income investors?
Bond markets are off to strong start in 2023, running with the downward inflation trend in the US. As a result, bond demand has picked up and government bond yields have rallied. This has benefitted our preference for adding US duration at the beginning of the year. In the near term, inflation, wage and economic growth data may keep government bond yields range bound. Ultimately, we prefer to remain structurally long US duration as we continue to see a 60% chance of the market pricing in a recession later this year.
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