The Supreme Leader

October 28, 2022

President Xi’s leadership may impact the global landscape for years to come. In the meantime, let’s hope for a quiet end to 2022.

US yields have declined over the past week, on growing hopes that a Fed pivot is approaching. This could see the FOMC slow the pace of monetary tightening in December, before halting rate hikes in Q1 next year. Next week’s Fed meeting will see a fourth consecutive move of 75bp, taking Fed Funds Target rate to 4%.

With policy having moved beyond where Powell and colleagues see the neutral rate, it is understandable that there will be a desire to slow the pace of tightening soon. Interest rate sensitive sectors of the economy, such as housing, appeared to have slowed to a halt. However, for the time being, core inflation remains at its cycle highs and with unemployment at its cycle low, this gives the FOMC little opportunity to adopt a more dovish stance, until data starts to co-operate.

There is a sense that the Fed can’t risk pausing too early when inflation is this high. With jobs and inflation data tending to lag, there is therefore a risk that those looking for the Fed pivot could be disappointed next week, and it may be necessary to see a turn in the data in the coming month before it is safe to price such a conclusion.

On this basis, although we are inclined to extend duration, we think that retaining a flat position makes more sense for the time being. Should yields rise following the Fed, then there may be opportunities to add long duration positions at more attractive entry levels.

This week’s ECB meeting delivered few surprises, with Lagarde raising rates by 75bp, taking the deposit rate to 1.5%. Notwithstanding the slowing of the Eurozone economy, the ECB seems likely to raise rates by another 100bp in the next few months, against the backdrop of problematic inflation. A peak in inflation seems only likely in late Q1 and consequently the ECB may continue to take rates higher, even after the Fed goes on hold, notwithstanding the economy in recession.

Meanwhile, plans to adjust terms on TLTROs should encourage early repayments under this facility, which should reduce excess reserves and lessen the squeeze on collateral. This may benefit swap spreads, which had been highlighting issues with respect to monetary policy transmission in recent weeks.

This week’s Bank of Japan meeting has also been a focus for attention. Inflation in Japan has also been creeping higher and today’s Tokyo CPI data showed annual inflation at 3.5%, with core CPI now slightly above the bank’s 2.0% inflation target and on a rising trend. Global pressures coupled with a weak yen have been pushing prices higher, but as inflation becomes a more elevated concern in Japan, so there is a growing sense that businesses, which have absorbed rising input costs, are suddenly more inclined to pass these costs on to consumers.

We believe that a policy of Yield Curve Control is no longer warranted and that Kuroda will look to exit before long. Policy divergence has pushed the yen to undervalued levels and with US policy continuing to tighten, there must be a concern that in the absence of a Japanese policy change, so pressure on the FX is unlikely to abate any time soon. Structurally speaking, we remain short JGBs in anticipation of a policy change. We have also adopted a modest long yen position in the hope that such a move may not be too far off, on the belief that the long-term fair value for the yen is probably closer to 125 than 150.

In a busy few days for central banks, the Bank of England (BoE) will also be in focus next week. The installation of Rishi Sunak as Prime Minister has seen the risk premia attached to UK assets continue to fall in the past week. It appears that Sunak is focussed on restoring fiscal sustainability and as he does so, lower gilt yields are helping him to mitigate the extent of tax rises or spending cuts that he might need, in order to balance the books.

We continue to expect smaller BoE interest rate hikes than markets discount over the next few months. Going into the November MPC meeting, it can be argued that the economy is in materially worse shape than was the case at the last meeting six weeks ago.

On this basis, it could be argued that Bailey should raise rates by no more than the 50bp, matching what was delivered in September. Ultimately the UK economy is much more sensitive to movements in short-term interest rates, as a function of the structure of the domestic mortgage market.

We are therefore inclined to look for a dovish surprise and have maintained a long position in UK short-term rates, since closing our short gilt position two weeks ago. Similarly we remain short in the pound relative to the euro. With twin deficits, a protracted recession and an extended inflation overshoot, UK fundamentals continue to be severely challenged. In this case the Rishi honeymoon (if there were to be one) is likely to prove very short lived.

Risk assets generally traded with a stronger tone over the past week. Equities rose on hopes for a Fed pivot, with support also coming from a relatively robust earnings season. Yet the fact that businesses have reported strong demand could be a further reason to be wary that the Fed will become dovish too soon.

Meanwhile, a rally in stocks and credit spreads have helped Financial Conditions indices to ease back towards their lows for the month. We think that this could suggest some vulnerability, as we approach policy meetings next week.

However, it is also becoming clear to us in end investor demand, that we have reached valuations in credit, where investors are increasingly inclined to put money to work. Excessive volatility in fixed income markets has been an impediment to this and thin liquidity conditions, coupled with macro uncertainty, could keep volatility elevated for the foreseeable future.

However, it is likely that markets will calm down at some point over the next couple of months, especially with the turmoil relating to UK LDI selling now fading into the background. On this basis, we continue to see value in corporate and sovereign issues, and remain more inclined to add on weakness than sell on strength.

Looking ahead

As we move into November, so it feels like we are moving into the home straight for 2022. This year has been exceptionally challenging for investors in many strategies, but as the dust settles, so we think we will face a more promising landscape for adding risk as we start to look ahead to 2023.

However, there is a sense in which we are left waiting on the data to confirm that inflation is turning and rates will peak and so there may be a few more bumps to navigate before a potential year-end rally.

Meanwhile, the latest Party Congress in China last week saw President Xi Jinping cement his position of control over the Chinese Communist Party. With dissenters removed, Xi now occupies a position which rivals that enjoyed by Chairman Mao more than half a century ago. With paranoia leading to an ever-increasing desire to control the population, our sense is that China will continue to look inward and away from the West.

In time, this may make conflict over Taiwan a more worrying prospect. It would also appear to condemn China to a future of more muted economic growth, with demographics set to ensure that China is the country which will grow old, before it manages to get rich. Geopolitical developments may thus continue to have a material bearing on the global landscape for years to come. Albeit, one can hope that this won’t need to be yet another problem we are having to tackle simultaneously in 2022; a year that has seemed to embody Everything, Everywhere, All at Once....

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