Will the Year of the Rabbit run out of steam?

January 20, 2023

As the tiger gives way to the rabbit on the Chinese zodiac calendar, we’re hoping for a lucky 2023.

Global financial markets have made a strong start to 2023, helped by supportive economic data and strong technical flows. Hopes that inflation may be slowing were buoyed by a benign US PPI report this week and with base effects meaning that energy prices now register a decline, on a year-over-year basis, there is hope that this could presage a move in CPI indices back to target in the months ahead, thereby allowing for a dovish pivot in monetary policy.

However, we would caution that core prices will be much slower to fall than headline data and it is core prices which will continue to guide the actions of policy makers. With labour markets remaining tight and economic activity still relatively healthy, it seems premature to believe that the Fed or the ECB will be announcing a turn in policy, for a while yet.

There is a narrative that the Fed will adjust its narrative and follow the market, but this seems to overlook the fact that Financial Conditions indices have eased over the past 3 months. It also strikes us that policymakers are paranoid of making a policy error, whereby they adopt a dovish stance too early, only for inflation to remain stuck at elevated levels.

From this standpoint, a somewhat better growth backdrop coming into 2023 enables central banks to retain a hawkish stance for now and we continue to see Fed Funds rate exceeding 5% in the spring, before the FOMC goes on hold. Thereafter, we think that rate cuts remain unlikely, before the final quarter of the year, unless there is a more sudden slowing of economic activity during the summer.

Similarly, we project rates in the Eurozone exceeding 3% in the spring, with the ECB likely to hike by 50bp at its next meeting. Unattributed comments this week suggested that the ECB may look to slow the pace of monetary tightening in March, but one can assume that these comments came more from the dovish camp within the ECB, rather than reflecting a more mainstream assessment.

Indeed ECB’s Knot was eager to signal a much more hawkish path. Although we expect debate to intensify within the Governing Council over the next few months, for now, we believe those in the hawkish camp are much more clearly in the ascendency, given the sheer magnitude of the inflation overshoot in 2022, which few had seen coming.

In light of this we have moved to a more bearish stance on euro yields, reducing duration by selling Italy BTPs on an outright basis. Sovereign spreads in the Eurozone have been behaving with a degree of positive correlation to yields and we think that the Italy spread may widen if bund yields correct higher. Ten-year German yields have declined by 50bp since the start of January, with Italian yields down by almost 100bp.

In part, this move has reflected a capitulation on the part of those who had maintained short positions. Yet, with this short base being cleared and with outright ten-year BTP yields declining below 3.8%, we think that there will be limited buying interest for long-dated Italian bonds, if investors can earn 3% or more from their cash deposits in the course of the months ahead.

Meanwhile, UK data on both wages and inflation suggest that 2023 is likely to see price pressures remaining more elevated than for other major developed economies. We continue to think that the Bank of England will be very wary of taking rates to, or beyond, 4% in the UK, for fear of crushing house prices. This vulnerability in the UK, plus a structurally tight labour market and elevated fiscal deficit, all make us bearish on the outlook for the months ahead, with this view seemingly most aptly expressed by an underweight in the pound.

We would also continue to highlight underlying vulnerability in the gilt market where negative convexity of demand continues to be a live issue. Simply put, if yields start to rise, then pension liabilities will fall and so there is less demand for gilts at lower prices.

At a time when supply is problematically large and when overseas investors are wary of owning UK assets, so there is a risk of renewed turmoil in gilts, should policy mis-steps occur. At least for now, the Sunak government will be thanking a mild winter and cheaper gas prices, but it is not clear how long its luck will last.

Elsewhere, intense speculation ahead of the Bank of Japan (BoJ) monetary policy meeting saw us reduce our short conviction stance on JGBs. With ten-year swaps reaching 1% in Japan at the start of this week, we were happy to reduce our position into the BoJ meeting, having generated positive returns to date. In the wake of the meeting, yields have subsequently fallen and we have added back to a short with ten-year swaps back below 0.80%.

In our view, the BoJ will need to raise the yield ceiling on purchases further and ultimately scrap the policy of Yield Curve Control (YCC) altogether in the course of the next few months. Inflation is trending higher and we think that it has the capacity to continue to surprise to the upside, with more businesses raising prices, now that the corporate ‘shame factor’ at having to announce price hike seems to have dissipated.

YCC has achieved its objective of inflation sustainably at 2%, but it is clear that Kuroda is caught in a communication trap. The BoJ Governor needs to show unswerving commitment to maintaining the status quo, or he will trigger a wave of speculation against the peg. This means policy changes will need to be a surprise and this is partly why the BoJ were wary of signalling a further change this week.

Over the past month, the BoJ have needed to buy bonds at an ever more rapid rate and figuratively, it may seem like the central bank is materially accelerating its asset purchases, even as it approaches a ‘Stop’ signal. Consequently, we would flag that an interim change in policy before the next scheduled meeting is possible. This could come in the wake of inflation data or the announcement of a new BoJ Governor in the middle of next month.

The notion that a Japanese policy change is a question of ‘when’, and not ‘if’, kept the yen well supported in the past week. A dip in the exchange rate, in the wake of an unchanged policy meeting proved short lived and it seems there is still interest to add to long yen positions in the speculative community.

Elsewhere, the dollar continues to weaken with the DXY Index remaining under pressure. However, we think that this trend may have run its course for now and that we may be towards the extremes of a ‘dollar smile’. To this point, lower core rates have contributed to a weaker dollar outcome, but in the situation that growth disappoints and takes core yields lower still, then the correlation that has been causing the dollar to fall, could easily flip the other way around.

Investor positioning has become short dollars, with positioning overweight in EM FX. Consequently, we have been happy to reduce FX beta, having positive contributions in the Thai baht and reducing the Brazil real, in order to adopt a neutral beta stance.

Credit spreads have rallied at the start of the year, with equities also posting positive returns. Better news on growth and inflation supports this price action. However, we would also note that there has been a strong desire to put cash to work with investors concluding that, in the wake of a disastrous year for beta returns in fixed income and equity asset classes in 2022, then surely 2023 must deliver a more promising outturn. We would not be surprised if this desire to deploy cash starts to wane towards the end of the month, meaning that the strong technical bid that has been driving markets starts to wane.

We are set to witness substantial net supply of fixed income in 2023, partly due to elevated fiscal deficits and central banks turning, from assets buyers, to asset sellers. This could risk crowding out in other sectors and although this has not been a factor to date, it is possible that this limits the extent to which yields can rally, even if IG credit continues to look well supported based on fundamentals.

We remain more concerned about credit impairment in private markets more generally speaking, whilst we continue to maintain a favourable stance on financials, with banks helped by increasing interest margins, even as provisions tick higher, against a deteriorating growth backdrop.

Looking ahead

This weekend marks the start of the New Year in China. 2022 turned into a Year of a Weeping Tiger, more than a Water Tiger, even if it has ended on a more hopeful note. 2023 marks the Year of the Rabbit, which seems to be off to a fast start. However, just as the rabbit ran out of steam after running ahead at the start of the race, we are concerned that we could see financial markets lose momentum in the weeks to come.

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