Fixed Income Perspectives

Is there mea culpa in central bankers’ tough talk?
There certainly is a big element of mea culpa in the central banks’ tough talk today. They have made mistakes. They have made big mistakes. And ironically, they're now betting that maybe two policy mistakes, two wrongs make a right. They over-eased; they had to due to the pandemic. And now they fear inflation is out of control, unless they contain it quickly, and that probably means breaking something. It's taken a long time for markets to actually come to the realisation that central banks don't really know how far, how high, and how fast they need to move. But they will only know probably if indeed they see some real signs of stress, real slowdown in credit creation, real knock-on effects to asset markets. These are the signs that you're having an impact. And for many that are accustomed to central banks riding to the rescue every time there was a problem or an issue in the global economy, this is very different. They're now intentionally trying to slow the economies below trend. And keep in mind that nominal growth is still quite high. To do this takes some real effort, and it will be a challenge for central banks to come anywhere close to pulling off a soft landing.

How challenging are lags for policy?
It's important to realise that central bank policy works with a lag. It might be three months, six, nine, or even 12, but the actions we're seeing today will still be playing out a year from now. And the reason that's important is the pace [of rate hikes] that we're seeing from central banks is unheard of. We haven't seen this in decades – 50 basis points, 75 basis points. These moves slow money, they increase borrowing costs, they weaken housing, and the effects are often self-reinforcing. So you have an issue today that, is much like a fairground mirror when you look at the economy. Look one way and it looks strong. The labour market is still buoyant. Wages are increasing. But look in other directions and you see housing weakening. You're seeing some credit stress beginning to emerge. I think the important thing is to realise which of those are lagging indicators and which are leading. The leading indicators are softening and they're softening very quickly. Labour markets, defaults, all these are lagging indicators. I think if you believe in this lag effect, you know, again, focus on the leads. And they're pointing toward a much softer growth trajectory, probably a softer inflation trajectory as well. But central banks have no margin for error. They are committed to making, if they have to make a mistake, make it on the side of being too tight, not too easy.

Is there a magic number at which the Fed declares victory?
There's often a question as to when central banks and when the Federal Reserve might stop. Is there a magic number, for example, on inflation? They've often used a 2% target. We are so far above that, however, that I think waiting for 2% is probably a bit of a pipe dream. I think for central banks, what they'll need to see is a real slowdown, a real move in that trajectory. So if inflation's going from eight or nine down to four, that directionality is going to be critical for them. They're going to have to feel that if they lighten up on the brakes just a bit, that they won't be reversing course in 3 to 6 months. They've done that once or twice. They're not going to let that happen again. So I think it's the real direction as well as something that's probably well under 4% to 5% before they can start to get comfortable. And it will also be informed, I think, by the growth trajectory, which is probably going to be softening at the same time.

Are regional divergences becoming more acute?
There's very clearly a common thread that's running through policy globally. Most developed world central banks are tightening. So are most emerging markets, with a few exceptions like China. But what is not the case is that all economies are performing the same. In fact, divergences are growing. I think the US looks better situated. The strong dollar should alleviate some inflationary pressures. Whereas in Europe the potential for a big energy crisis as we go into the winter months, I think, is a severe drag on growth, but also a tail risk. And so as we look around the globe, what we see are some emerging market countries already in easing mode. But China has such a debt load, whether they can actually ease quickly enough to absorb the global slowdown, I think, remains a big question. Other economies are going to be highly volatile, probably at risk of both policy overshoot, energy prices, commodity prices, and various geopolitical risks. So it's going to be a very interesting period in which we slow to recessionary levels of growth in many regions. I think that is much more likely again in Europe and the UK than it is in the US. But expect to see divergence in economic behaviour. You'll see commonality I think in a lot of central bank responses, but that does not mean that all markets or economies will behave in the same way.

Might investors shift their asset allocations?
As with all inflection points in economies and markets, they can be great opportunities to reallocate assets. They can be opportunities to make mistakes. And so I always think that we need to focus on where the best risk-adjusted returns are. Make sure you avoid the downside by trying to maximise those opportunities. And what we've seen is a huge increase in interest rates, really across the world and across the entire yield curve. So I think bonds are offering more value. And I'm talking about government bonds, investment grade credit, probably offering more value than at any point in the last 5 to 6 years at least. Policy is moving higher, but equally that is now reflected in markets. And so the higher rates are really reflecting a tighter monetary policy backdrop. So there's value there. I think there is also likely to be diversification benefit, should we see the slowdown unfold. I think to go out into riskier areas of the market, I would personally wait until we get a bit more evidence that the downturn won't have a more serious impact on earnings and credit quality. I think we'll likely get that in the coming months. So I would say be nimble, focus on where the leverage has not been built up. So mortgages, asset backs, a lot of those sectors are actually benefitting from the strong consumer. Corporate credit, in investment grade, it also looks quite compelling at these wider spreads. And government bonds are giving you more income than they have in many, many years. So I would look to allocate there, expecting those diversification benefits that we used to see from bonds, you know, begin to re-emerge.