15 September 2023
Weekly Market View
Are the central banks done?
The world’s major central banks are almost done with rate hikes. That was the underlying message from the European Central Bank this week, a message likely to be echoed by policymakers from the US and UK next week.
The Bank of England could hike once or twice more, given persistent wage pressures, but slowing growth, especially in Europe, suggests policymakers will soon be done with their job of taming inflation and shift their focus towards avoiding a hard landing.
We see an opportunity for investors to move their cash into longer-maturity Developed Market government bonds within a diversified allocation. This is because government bond yields typically peak around the time policy rates peak.
The Bank of Japan is an outlier among major central banks, as it warms up to ending its ultra-loose policy due to rising inflation pressure. However, a moderate monetary policy tightening is unlikely to dent the outperformance of Japanese equities.
Has the US yield curve failed as a US recession indicator? What is the outlook for the curve?
Is it time to buy Emerging Market bonds?
Has the JPY bottomed?
Charts of the week: Peak rates positive for bond returns
Bonds have historically outperformed equities during a recession; the bond yield curve bottomed ahead of a recession
Money market expectations of Developed Market policy rates
12m returns for US stocks and bonds after recession starts
Source: Bloomberg, Standard Chartered; ^excludes 2020 COVID recession; *after recession starts; **from the time yield curve is most inverted
Editorial
Are the central banks done?
The world’s major central banks are almost done with rate hikes. That was the underlying message from the European Central Bank this week, a message likely to be echoed by policymakers from the US and UK next week. The Bank of England could hike once or twice more, given persistent wage pressures, but slowing growth, especially in Europe, suggests policymakers will soon be done with their job of taming inflation and shift their focus towards avoiding a hard landing.
Investment implications: We see an opportunity for investors to move their cash into longer-maturity Developed Market government bonds within a diversified foundation allocation, since government bond yields typically peak around the time policy rates peak (see page 4 for more details). The Bank of Japan is an outlier among major central banks, as it warms up to ending its ultra-loose policy due to rising inflation pressure. However, a moderate monetary policy tightening is unlikely to dent the outperformance of Japanese equities, given the upturn in corporate earnings, rising corporate dividends and buybacks. In FX, the EUR/USD’s sharp decline to a six-month low following the ECB’s dovish hike raises the risk of further downside towards 1.0520 support in the next 2-4 weeks. GBP/USD broke below a key support around its 200DMA at 1.24, opening the way for a test of 1.22 in the coming weeks.
Fed watch: We see low probability of the Fed hiking this month. The Powell-led Fed has rarely surprised markets and markets are not expecting a hike next week. While the US central bank could keep the door open for one last hike in November, given the latest bounce in core inflation to 0.3% m/m, a still-tight job market and the ongoing rebound in oil prices, we expect a downturn in growth later this year to sustain the disinflationary trend. The Fed’s new growth, inflation and rates (‘dot plot’) forecasts will be keenly watched. Any upward revision of the median long-run rate
estimate would signal that the Fed believes rates are not tight enough despite the 525bps of hikes in this cycle, taking rates to a 22-year high.
Do we still get a US recession? A US recession over the next 6-12 months remains our base case. The US Leading Indicator (LEI) has reported a y/y decline for the past 16 months. The US has never avoided a recession after such a long stretch of decline in the indicator. Similarly, the US government bond yield curve has remained inverted (shorter tenure bond yields have remained above longer tenure bond yields, an unusual phenomenon) since July last year. At its extreme in March and July this year, the US 10-year bond yield was almost 111bps lower than the 2-year yield, the biggest inversion since 1981. Historically, a US recession has started 9-22 months (median: 16 months) after the 10-year yield fell below the 2-year yield (this cycle: July 2022), 2-16 months after the curve became most inverted (this cycle: March and July 2023), and 2-6 months after the curve sustainably turned positive again (yet to happen, although in 1982, the curve turned positive almost a year after the recession had started). Based on this history, there is a high probability of a recession starting anytime from Q4 this year to Q2 2024.
A near-term upturn?: While the unusually rapid pace of rate hikes in this cycle raises the odds of a recession, the long historical lags and the wide ranges mean we should not be surprised if a recession started as late as mid-2024. Indeed, this cycle has been extended by the unprecedented fiscal stimulus during COVID, leading to a consumption boom, and the follow up stimulus from President Biden’s green infrastructure fiscal package, leading to a rebound in manufacturing capex. Nevertheless, we expect the impact of high policy rates, depletion of excess consumer savings and fading of the fiscal stimulus to eventually lead to a downturn in economic activity over the next 6-12 months, forcing the central banks to start cutting rates next year. Rate cuts next would provide a fillip to Developed Market government bonds.
— Rajat Bhattacharya
The weekly macro balance sheet
Our weekly net assessment: On balance, we see the past week’s data and policy as neutral for risk assets in the near term
(+) factor: China activity stabilising, credit expansion, ECB rate peak
(-) factor: Rising US inflation, geopolitical tensions
US headline inflation rose more than expected in August due to rise in gasoline and shelter prices
US headline, core and supercore* inflation
Euro area economic sentiment and expectations remain downbeat
Euro area ZEW survey of current sentiment and growth expectations
China retail sales and industrial production growth accelerated more than expected in August, but fixed asset investment slowed more than expected
China’s retail sales, industrial production and fixed asset investment growth
Top client questions
Has the yield curve failed as a recession indicator? What is the outlook for the yield curve from here?
An inverted yield curve, a term used to describe periods when long-term bond yields are lower than short-term bond yields, is commonly used as an indicator of recession. In the last four US cycles, when the 10-year versus 2-year yield curve (10Y2Y) became inverted, a recession typically followed in the next 2 to 16 months. In this cycle, the 10Y2Y yield curve has been persistently inverted since July 2022 and the US economy is still running hot. Here we try to explore what makes this cycle so different.
1. The COVID-19 stimulus ‘bazooka’ has likely extended the longevity of this cycle. Households were able to accumulate excess savings from handouts during the pandemic, which helped sustained a more extended period of stronger-than-expected spending than previous cycles.
2. Although global central banks have been raising interest rates at an unusually rapid rate, earnings data and credit ratings suggest the corporate sector seems to have uphold strong business activities and hence extended the economic lifecycle.
Having said that, we retain our view that a US recession remains likely in 2024. We believe the stimulus/surplus savings from the COVID-19 era is running out of steam. Financial conditions have tightened, predominantly due to higher interest rates. The negative effect of both is already visible in several leading economic indicators.
We believe odds favour a steeper (ie, less inverted) yield curve from here. The Fed has likely reached the end of this hiking cycle, abating upside pressure on short-term yields. In addition, we expect the Fed to cut interest rate in 2024 in response to weaker economic growth. Our analysis of recession episodes since 1980s shows (1) it has taken average 11 months for the 10Y2Y curve to return to the positive territory after it bottoms and (2) the 10Y2Y steepened across all recessions by an average of 139bps.
— Cedric Lam, Senior Investment Strategist
— Qi Xiu Tay, Investment Strategist
The US 10Y2Y government bond yield curve has steepened across all recession episodes we studied since the 1980s
The trough of the 10Y2Y yield curve inversion, months it took to return to positive and measure of yield curve steepening (bps) during recession
Top client questions (cont’d)
Is it time to buy Emerging Market bonds?
Emerging Market (EM) USD and local currency bonds have pulled back after hitting their 2023 high in July. A rise in US government bond yields and the strength in the USD, respectively, have been the key drivers for the subdued performance. While we think the pullback offers a good entry point for EM local currency bonds, we would still remain cautious on EM USD government bonds.
Historically, FX returns have been a prominent driver for EM local currency bonds. While the recent bounce in the USD has undoubtedly hurt them, we expect the USD to weaken over the next 12 months, which should provide a returns tailwind. Additionally, EM central banks are further along the interest rate cycle than their DM counterparts. We are close to the peak of a hiking cycle for most EM countries, and some have even started cutting rates, which should again be supportive for returns.
While credit spreads or yield premiums for EM USD government bonds look optically attractive, they are justified to compensate investors for the deterioration in credit quality. Spreads of IG sovereign bonds are in fact quite expensive relative to historical average. It could be argued that the elevated HY spreads are still insufficient to compensate investors for the increase in default risk. Hence, we remain Underweight on EM USD government bonds.
— Abhilash Narayan, Senior Investment Strategist
EM USD IG government bond yields premiums are fairly expensive; HY spreads are justifiably high due to deterioration in credit quality
EM USD government bond IG and HY sub-index yield premiums
Has the JPY bottomed?
USD/JPY’s bullish trend continued to push fresh highs in the first week of September. However, towards the end of last week, Ueda said ending negative rates would be an option once the BoJ’s goal of sustainable 2% inflation is achieved. With Japan’s latest improved GDP growth and inflation data recently, currently the market is expecting BoJ to end negative rates by early 2024. The JPY gained strength as the 10-year JGB rate moved higher (rose to 0.71%, its highest since January 2014) and limited the latter’s upside risk.
On the other side, the Fed is expected to maintain policy rates for an extended period, while interest rates in Japan are not likely to rise significantly, even if the BoJ ends its negative rate policy. This means the JPY could continue facing downward pressure before any new updates from either the Fed or BoJ. Meanwhile, the Greenback looks overvalued now with technical correction risk; therefore, we expect USD/JPY to rangebound with a bearish bias. Technically, the pair is trading above 50d SMA, its relative strength index is in a neutral zone at 59 but at the edge of its Bollinger band upper bound, and the upside risk is limited with significant resistance at 151.90. The pair is likely to test its support at 144.40 in the upcoming 2-3 weeks.
— Iris Yuen, Investment Strategist
USD/JPY surged alongside the interest rate differential between the US and Japan, but is now close to a technical resistance
USD/JPY and interest rate differentials
Top client questions (cont’d)
What are the implications of the Bank of Japan’s recent hawkish comments on Japanese equities?
BoJ Governor Ueda’s interview last week hinted at a potential end to Japan’s negative interest rate regime. In response to his hawkish comments, the JGB 10-year yield has surged to above 0.7% ahead of the BoJ policy meeting next week – a level not seen since 2014.
Overall, Japan remains our preferred equity market on a 6-12 month horizon amid its relatively relaxed monetary policies, as compared with other developed markets, and measures to support corporate governance. We expect the potential relaxation in its prolonged Yield Curve Control policy to be supportive of the financial sector in particular, because major domestic banks benefit from higher interest income. The MSCI Japan Financial index has been outperforming the broader Japan market this year, rising almost 50% YTD. However, valuations remain appealing, with the sector’s 12m forward P/E currently trading at 11.7x, below its historical averages, despite elevated 12m forward EPS growth expectations of 12.4% – substantially above the expected earnings growth in the broader Japan market.
— Michelle Kam, Investment Strategist
Performances of Japan’s financial sector is closely related to its government bond yield
Relative performance of MSCI Japan Financials index and JGB 10y yield
Market performance summary*
Our 12-month asset class views at a glance
Economic and market calendar
The next resistance for the US 10Y bond yield is at 4.30%
Technical indicators for key markets as of 14 September close
Investor diversity is healthy in global equities and bonds
Our proprietary market diversity indicators as of 14 September
For more CIO Office insights
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Uganda: Our Investment products and services are distributed by Standard Chartered Bank Uganda Limited, which is licensed by the Capital Markets Authority as an investment adviser. United Kingdom: In the UK, Standard Chartered Bank is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority. This communication has been approved by Standard Chartered Bank for the purposes of Section 21 (2) (b) of the United Kingdom’s Financial Services and Markets Act 2000 (“FSMA”) as amended in 2010 and 2012 only. Standard Chartered Bank (trading as Standard Chartered Private Bank) is also an authorised financial services provider (license number 45747) in terms of the South African Financial Advisory and Intermediary Services Act, 2002. The Materials have not been prepared in accordance with UK legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead of the dissemination of investment research. Vietnam: This document is being distributed in Vietnam by, and is attributable to, Standard Chartered Bank (Vietnam) Limited which is mainly regulated by State Bank of Vietnam (SBV). Recipients in Vietnam should contact Standard Chartered Bank (Vietnam) Limited for any queries regarding any content of this document. Zambia: This document is distributed by Standard Chartered Bank Zambia Plc, a company incorporated in Zambia and registered as a commercial bank and licensed by the Bank of Zambia under the Banking and Financial Services Act Chapter 387 of the Laws of Zambia.