07 October 2022
The central bank peloton
Weaker US macroeconomic data may begin to slow the pace of Federal Reserve (Fed) rate hikes, potentially providing a chance for other central banks to catch-up.
Any cyclist will know that it’s hard work to break away from the peloton. The sheer effort required to go it alone and open a gap between yourself and other cyclists is often short lived as the peloton sucks you back in. The same is true with the central banks and hiking cycles. It has been six months since the Fed took off and began to tighten monetary policy. However, there are now signs that the US economy is beginning to tire, as job openings fell sharply in August and household personal savings rates have slumped to their lowest levels in nearly 17 years. It is still early days, but eventually the headwind of higher interest rates may force the Fed to slow the pace of monetary policy tightening, which could provide an opportunity for other central banks to close the gap. Both the eurozone and the UK have been slower to tightening monetary policy compared to the US however, double-digit inflation prints, fuelled further by sharp declines in their currencies, is likely to prompt a meaningful response from the European Central Bank (ECB) and Bank of England (BoE) in the coming months. In addition to rate hikes, the ECB is also discussing the possibility of shrinking the size of its bond holdings – currently €5 trillion – in early 2023, a move which would further close the gap on the Fed.
One of the most pronounced macro developments has been the sharp appreciation in the US dollar over the last year due to the energy independence of the US. A moderation in the energy crisis could see a more stable dollar and begin to attract capital flows back into other regions. One asset class that may benefit from stability in the dollar is emerging market (EM) debt. A stronger dollar can be a headache for EM economies, which typically have a proportion of their sovereign debt denominated in dollars as well as a need to import goods and commodities, which are also typically priced in dollars. While a more stable dollar should help support EM fundamentals, the valuations in the asset class, particularly in EM local debt, look relatively attractive. Many EM central banks have been on the front foot in tackling higher inflation and regional sovereign bond markets are offering up attractive yields, particularly in Latin America and parts of Asia.
The monetary policy gap is beginning to close as the ECB and BoE catch up
Ongoing fears regarding Europe’s energy crisis and relatively high interest rates in the US has fuelled significant inflows into US dollar denominated assets, as investors have sought the safety of the greenback. While the gap between the Fed and other central banks may close gradually in the coming months, policymakers are not yet ready to pause their pursuit of lower inflation. Overall, global monetary policy will continue to tighten which likely explains why investors have continued to be wary of jumping into bond markets and why the duration of bond portfolios remain underweight versus history.
What does this mean for fixed income investors?
With inflation still well above target, central banks are going to continue to tighten monetary policy however, there are signs that the Fed’s aggressive rate hiking cycle is taking a toll on the economy. Going forward, the monetary policy gap between the Fed and other central banks might begin to close as the ECB and BoE play catch-up and the Fed slows its ascent. Investors should therefore be mindful that we could be approaching a stable platform to explore options in emerging market debt where improving fundamentals and relatively attractive valuations are on offer.
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.
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are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum