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Global Rates: The shift away from stagflation

2022 was characterised by multiple shocks hitting the global economy. Between leaving the pandemic behind, the surge in inflation, Ukraine-Russia conflict, aggressive central bank actions across the DM, financial stability issues and growth worries, it has been incredibly rapid pace of re-pricing and reassessment of the balance of risks. For the rates space, implied and realized volatility were both very high by recent standards (past couple of decades) as nominal rates shifted into a higher for longer regime. 2023 will likely mark an evolution of the themes that played out. A series of changes and the sequence of the shifts matter. We find it useful to classify economic conditions into four scenarios, each toggling between high / low inflation and high / low economic activity. The global economy has generally been stuck in the stagflation phase for several quarters. The shift away from stagflation (and when this will occur) into the other quadrants will move rates pricing again. We take a stab at timing, sequencing and the developments that would dictate DM rates through 2023.

We think that the current stagflation backdrop will give way into a period of slower economic activity / lower inflation (recession) or one of resilient economic activity / lower inflation (Goldilocks). There is also a reasonable chance that we cycle through all three of the quadrants, depending on how the sequencing of events play out. Taking stock of how the rates space has adjusted in 2023, we think that curve flattening is probably the single biggest shift for 2022. Note that the 2Y/10Y bear flattened from around 80bps at the start of 2022 to an inversion of around 70bps in November, levels not seen since the early 1980s. We suspect that the combination of a hawkish Fed, aggressive hikes and very high inflation prints would fade in late 1Q/2Q. The Fed has already indicated that it is poised to downshift in December. By 1Q, we think that the terminal rate of 5% would be hit. At that point, the vantage point should be different, and a pause would be needed to assess the impact to the economy. Across the DM, we might well find that many central banks would probably be close to the tail end of their respective tightening cycle. In any case, a shift from stagflation into recession / Goldilocks point to lower yields (especially for the longer end). Japan is the notable exception. There are lingering risks that the BOJ might opt to ease up on yield curve control in 1H23 (especially given that CPI had hit 3.8% YoY in October).

The impact on the curve is less clear depending on whether the pricing lurches into recession or Goldilocks or both through 2023. The US economy has so far surprised on the upside, staying resilient despite bouts of financial stress and much higher rates. While there are reports of layoffs (especially in the tech sector), these have not impacted jobless claims or payrolls yet. We are also somewhat wary that there may be industry shifts (downturn for tech and manufacturing) that may be offset by firm labour demand in other services sectors. If this is the case, the labour market might well stay tight for longer than investors anticipate. Moreover, external factors such as China reopening (plausible around mid-2023) also have considerable impact on global growth. Our suspicion is that stagflation would give way to recession pricing first and potentially Goldilocks thereafter if the global economy holds up better than expected in 2H23.

Recession pricing would mean steeper curves and we think this would play out in the 5Y/30Y, 5/10Y and eventually the 2Y/10Y (in that order). We also like holding on to receiving 2Y/5Y/10Y fly. The key motivation is that this economic cycle is slowing and rate cuts got to feature into the 2Y to 5Y tenors. However, if inflation is now structurally higher than the pre-pandemic era, longer term rates should be more buoyant. We should also be keeping an eye on MBS sales in 2023. However, the US could well only suffer a minor recession. There is no way to assess the impact of monetary tightening until a couple of quarters later. If it turns out that the economy is resilient and the curve might steepen (led by the long end), paring pessimism on global growth. We have also laid out the performance of the different tenors and segments of the curve for the past seven Fed cycles stretching back to the 1970s. (see table at bottom of next page) The findings agree with the strategies laid out above.

US Strategy

In the immediate few months, we think holding to receive 2Y/5Y/10Y fly still makes sense. Beyond that, we think that the case for steepening (5Y/30) and eventually 2Y/10Y is strong in 2023. A shift away from stagflation pricing (into recession or Goldilocks) will almost certainly lead to lower rates and steeper curves. This shift might well take place in late 1Q. In which case, 5Y/30Y should have a positive spread while 2Y/10Y might move towards par, depending on how bad of a slowdown plays out. We would also fade Fed cuts in 2023 relative to peak pricing in 2Q. 2 cuts priced into 2H23 does seem a tad excessive.

Asia Rates: Fed, US slowdown and China’s reopening

2022 has turned out to be a second straight year of challenging conditions for Asia rates and bonds. A hawkish Fed hiked aggressively to respond to the highest US inflation in four decades, and in the process, pushed up US rates and the broad USD. Here in Asia, central banks also have had to embark on hiking cycles to tame high inflation and offset currency depreciation pressures.

We expect improved sentiments and the dynamics of falling US inflation, Fed turning more data-dependent and China's reopening process to carry forward into next year. In 1Q, short-term US rates should stabilize as we approach the end of this Fed hike cycle, the broad USD could be less supported, and China's cyclical outlook would further improve on incremental reopening progress. As such, in 1Q, we expect Asia rates and bonds to continue to recover from the losses of 2021-2022. For Asia central banks, we expect BOK and RBI to also conclude their hiking cycle in 1Q, as with the Fed. Central banks like BNM and BOT, because of their more gradual hike pace, could see their hike cycles extend for a couple more quarters.

Moving beyond 1Q of 2023, we think the outlook for Asia rates and bonds could be more uncertain and would depend on whether US and Asia inflation stay elevated or fall towards target as we expect, and whether a prolonged period of restrictive global policy rates would eventually drive recession risks. Below are three key themes that we see for 2023 and our base case expectations around them.

Theme 1: Inflation falls, and Fed pauses at 5% terminal rates

We are forecasting inflation to fall closer towards target next year, such that US and Asia (ex China) central banks would be able to end their hike cycles in 2023. This should be a favourable macro set-up for Asia (ex China) bonds to recover and yields to be stable-to-lower, unless global or US growth sharply decelerates and triggers risk-off sentiments. Some of the foreign capital that left in 2021-2022 could return, and foreign holdings of Asia bonds should rebound.

We however expect the recovery in Asia (ex China) bonds to lag other EM regions, as Asia central banks have not hiked rates as much as other EM regions and Asia bond valuations lean expensive.

Theme 2: China reopening

We think COVID restrictions/measures will be gradually relaxed, and China will reopen more fully around mid-2023, though loosening of international travel restrictions could be further out. CNY rates would be firmly on an upward trajectory in 2023 while US and rest of Asia rates appear to have peaked, suggesting that China-US and China-Asia rate differentials have bottomed and would be on a widening trend from here.

China reopening would impact the rest of Asia via two channels. The first channel would be through trade and tourism. Bonds of Asian economies with larger and direct exposures to China, either via trade or tourism, should disproportionately benefit and outperform.

For tourism, we look at Chinese tourists as a percentage of total tourist arrivals and scale by the size of the tourism sector relative to GDP. Thailand would benefit most from the resumption of international travel by Chinese tourists (Korea used to see a lot of Chinese tourists but the size of its tourism sector is relatively small).

For trade, exports to China as a percentage of total exports is largest for Korea. Therefore, Korea KTB and Thai LB bonds are two of our top picks in 2023, that could ride on the wave of China reopening.

A second channel of impact would be via higher oil and commodity prices, that would be driven by increased Chinese demand on the back of greater economic activity and infrastructure investments. Higher oil prices are broadly negative for the Asia region as most countries are net importers. Higher oil prices would also likely lead to some pressures on inflation, fiscal (due to subsidies) and current account balances, as we have seen this year around Russia-Ukraine. The bigger risk is that oil and commodity prices rebound on increased China demand, and as a result, inflation in US and Asia doesn't fall as we have anticipated, and Asia current accounts come under renewed pressures.

Theme 3: US growth slowdown and curve-steepening

We project that US growth would be slowing down as the US real policy rate widens. Come 2H of 2023, the Fed could be sufficiently concerned about growth risks and start to hint at a possible easing cycle (which we think would start in 1Q of 2024). This should be the signal for Asia rates curves to bull-steepen and unwind a large portion of the flattening that occurred in 2022. If US growth risks were to be severe, markets could go risk-off and we could see curves of high-yielders such as India and Indonesia bear-steepen instead as risk premium widens.

Our Asia bond picks for 2023

On a total returns’ basis, we are overweight Korea KTBs, Thai LBs and IndoGBs. We are underweight China CGBs and India GSecs.

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Eugene Leow

Senior Rates Strategist - G3 & Asia

[email protected]