The overall theme of 2023 will be confusion. The current geopolitical macro-economic back drop could deliver such a broad array of outcomes that it’s anyone’s guess where we will be at the end of the year. Looking back at my 2022 outlook made me chuckle … I had said, “inflation is less transitory,” and predicted the Fed raising rates by 75 bp by the end of 2022. Oh, how naïve. Just in the last few weeks of this year central banks have made it clear that they have a lot more to do. I predict the next year will be full of surprises, some more shocking than others, with outcomes that we might never have imagined, (like the Fed raising rates by 425 bp, not just 75.)
USD Monetary Policy — 2023 will see the end to the most dramatic monetary policy tightening since the heady days of Chairman Volker. The Fed wrapped up 2022 having raised their policy rate by 425 bp over just 9 months (March-December). So now the debate begins: when will they be done? My bet is on the last 25 bp in March, which should push cash yields close to 5%, a level not seen since 2006. Glory, glory for those of us sitting in cash! But how long will they remain at their high?
Fed officials are doing their best to convince us it will be a year, but the futures market is pricing ~50 bp of policy rate ease by the end of next year (at the time of this writing). For this to happen, of course, it matters what path inflation takes. Could there be negative inflation prints (MoM) in 2023? Yes, there could. Would that cause the Fed to pivot more dramatically? Yes, probably. What will likely be most important: jobs. The labor market has been tight, wage gains strong and worker confidence high. Non-farm payrolls have grown 480k/month on average since Jan ’21. We have not seen an unemployment rate this low (3.7%) for this long since the 1960s. No wonder the Fed finds taming inflation so challenging, everyone’s got more money in their pocket. Or maybe had more money, the US savings rate is at a 20-year low.
Figure 1: US Savings Rate at a 20-Year Low
When looking at the relationship between inflation and employment, it has been observed over a 50-year time period in certain major industrial economies that a decline in inflation of at least two percentage points has also been accompanied by an increase in the unemployment rate in relatively equal measure. Perhaps this time is different given the speed and reason for the increase in inflation. We can add it to the list of varied potential outcomes in this year’s economic outlook. Keep a close eye on the weekly jobless claims data to gage how hard or soft a landing we could see.
Figure 2: US Unemployment Rate
The part I find most interesting about the Fed’s policy path thus far are their ‘dots’. The dots represent where they see their policy rate at various future dates. Most Fed officials will tell you they don’t like doing them and to not pay too much attention to them, but we still do. For 2024, Fed officials have a 250 bp dispersion in where they think the policy rate will be, spanning from a low of 3% to a high of 5.5%. The dispersion in 2025 is even wider with a high of 5.5% and a low of 2.25%. So many differences of opinion!1
US Rates and Credit markets seemingly have already priced in the Fed’s policy ease and the recovery from the recession. At the time of this writing, 10yr UST yields are ~3.5% and trending lower. Investment grade credit spreads are +130 bp over comparable UST and trending tighter. Both imply the worst is behind us, but I’m not so sure. As we know, things can change quickly. Simply look at the repricing we saw in UST rates in August after Chair Powell’s Jackson Hole speech, or more recently, look at what is happening right now in the European rates market on the heels of President Lagarde’s hawkish tone on the ECB’s monetary policy rate. Italian and German 2yr yields are 70+bp higher in December. Central Banks are determined to win. Whether or not they do a lot of economic damage in the process is yet to be determined, but they will snuff out inflation.
Figure 3: German and Italian 2-Year Yields Spike Up
The Debt Ceiling will once again be front of mind in ’23. At the end of ’22, the US Treasury was very close to hitting the $31.4 trillion debt limit set by congress a year earlier – the Federal debt totaled ~$31.3 trillion, or about 122% of GDP, as of mid-November. For context, 20 years ago the gross federal debt stood at $5.8 trillion, or about 55% of GDP.2 It appears the Treasury is using some of the cash on hand in their Treasury General Account (TGA) so as to not trigger the ‘bind date’ or the date when they would be operating under extraordinary measures. At the time of this writing, it appears that the bind date might come in February, with the Treasury running out of money sometime in the 3rd quarter. Of course, this is all a guessing game as there are so many variables that can move these dates around.
Nevertheless, I suspect T-Bill issuance might be tight for the coming two quarters. We do expect an uptick in T-Bill issuance in Q1 as those filing their taxes early, expecting a refund, require the Treasury to issue Bills to pay these refunds. Then in the second quarter, there is a significant paydown in Bills as tax receipts refill the TGA. According to some market experts, the big increase in T-Bills won’t come until the debt ceiling has been resolved and the Treasury can resume normal operations. Expect that sometime in the second half of the year.
Figure 4: US Treasury Total Public Debt
EUR Monetary Policy continues to lag. The ECB remains behind on their policy rate hikes and has a lot more wood to chop. After raising rates by 250 bp in 2022, it is expected they will carry on with at least another 100 bp of tightening in 2023, with the market pricing in a peak of 3.2% in the second half of 2023. President Lagarde, as noted, will keep pushing rates higher to snuff out inflation. Their inflation outlook for 2023 has it cooling to 3.6% by year end, and ultimately back to the desired 2% by 2025. The easing energy shock will be the main contributor to cooling inflation, but other pricing pressures should similarly cool with monetary policy effects taking hold.
Tightening monetary policy comes at a cost to growth: GPD forecasts show 0.5% growth in ’23, slightly improving to 1.9% in ’24 and 1.8% in ’25.3 Quantitative tightening will have a cautious start in Q2 of ’23 with an expected 15bln per month. That means 1/3-1/2 of Asset Purchase Program (QE) maturities not being reinvested. If all goes smoothly at the start, we could see an acceleration in the pace later in the year.
GBP Monetary Policy is walking the tightrope. As is the story with other central banks, the BOE’s monetary policy committee (MPC) must work hard to squash out persistent inflation pressures. The market is pricing a terminal rate of around 4.70% in the second half of 2023. The MPC recognizes the challenge as economic projections put their economy in recession in ’23 and into ’24. Even with this slowdown in growth, the committee sees a tight labor market and the need to nip inflation before it becomes entrenched. There is risk they must push the economy further into recession to generate the necessary slack in the labor force to quell inflation pressures. All this while dealing with the rebalancing of the energy supply and demand on labor post-Brexit. Both Mr. Sunak and Mr. Bailey have a long and difficult row to hoe.
The SEC’s US Money Market Reform announcement appears to be delayed. Recall the most discussed and debated rule change was the application of swing pricing on Institutional Prime Money Market funds. Based on the industry comment letters submitted, the implementation of swing pricing as proposed would be unworkable and thus, it is assumed those remaining prime money market funds would close. The SEC had posted on their website that a tentative announcement date might come in October ’22. We now wait on the edge of our seats to see if prime funds go the way of Aerys Targaryen. It is expected the SEC commissioners would vote along party lines. Gary Gensler (Dem), Caroline Crenshaw (Dem), and Jaime Lizarraga (Dem) should vote to implement swing pricing. Supposedly Hester Peirce (Rep), Mark Uyeda (Rep) are open to a softer rule change that would allow prime funds to continue to operate.
Currently there is rumor of one of the Democratic commissioners reconsidering their decision and not supporting the rule change as it was put forth in the SEC’s proposal.4 The more interesting part of this puzzle is that the majority of AUM in these funds ($474bln of the $657bln total as of Dec 20, 2022, from Crane Data) is part of the “sweep” function. For some of the largest mutual fund companies, like Vanguard, Fidelity and American Funds, end of day cash is swept into these funds as part of the cash management function. As such, these funds are not really subject to “run risk” as they are part of an internal cash management process. So as the saying goes, the SEC might be throwing the baby out with the bath water. The rule change might only impact a very small portion of the overall cash in Institutional Prime MMF. There has always been concern that if you outlaw prime funds, where does the cash go? Perhaps, simply, into government funds or perhaps it ends up out of the SEC’s purview, and maybe that is just what they want.
Will this change impact credit conditions in the money markets? Perhaps. We did see substantial repricing in the summer of 2016 prior to the implementation of the October 2016 prime money market fund reform. And markets rebounded relatively quickly. As time went on credit conditions reverted back to their pre-reform levels, in some cases even better. I would suspect the same would happen this time.
One other not so small matter that the SEC will decide is whether government and treasury money market funds need to float their NAV in a negative interest rate environment. The lunacy of this potential rule cannot be understated. Whomever drafted it does not know the simple fact that so many systems that support the ownership of a money market fund cannot handle a variable NAV. This is the primary reason the industry saw over $1trillion of AUM move out of variable NAV prime funds in the fall of 2016. I hope the committee has come to their senses on this and will allow for reverse distribution in the event cash yields go negative.
European Money Market Reform — Reform for European domiciled money market funds remains a long way off. The current Presidency of the European Commission sits in Sweden. A country with little or no connection to money market funds. We don’t expect any substantial progress on this until end of ’23 or beginning of ’24. As one might remember from the last time Europe embarked on money fund reform the process is politically charged. Expect to hear more from us as this tale unfolds.
ESG in Cash — ESG and Prime money market funds in the United States have not grown as one would have hoped, and to be honest I’m not sure if this is an ESG challenge or a prime money market fund challenge. I tend to think the latter. Over the past several years there were five ESG prime funds that were either launched or converted from existing prime funds. The funds have either closed or have not seen growth due to their ESG label. A few of these funds were small (<$5 billion) and that in of itself is a challenge for the MMF investor. And with pending MMF reform, investors seem content to sit in Government or Treasury funds rather than “risk it” in prime.
But there is a silver lining: Diversity, Equity and Inclusion (DEI) strategies have done well. Some funds were created or converted, but more often individual share classes that focus on a specific cause were created off of existing money market funds. These causes can include partnering with a specific broker/dealer or contributing some portion of a fund’s revenue to a particular cause. The growth has been concentrated in government or treasury funds and clients have been pleased with this approach as they can benefit from all of the existing positive attributes of a money market fund while also knowing they are contributing to the minority broker/dealer or charitable cause
ESG in Europe remains focused on appropriate labeling within the Sustainable Finance Disclosure Regulation (SFDR) construct. Articles 6, 8 & 9 clearly outline what is necessary to have a classification. At the time of this writing, our funds continue to be categorized at Article 6. We are listening closely to investors and will continue to evaluate those strategies and analyze what would be best for the fund and the shareholders.
Conclusion — If you are still reading at this point, congratulations to me, I kept you engaged. Either that, or you skipped to the end in search of a summary to my rambling. To wrap up, 2023 will be a year when global inflation declines, central banks raise rates further than they need to, and economic growth slows to a crawl. The labor market will be the most important indicator of a hard or soft economic landing. If only modest layoffs ensue, perhaps central banks can thread the needle and engineer a soft landing. This author has his doubts. All of this means sitting in cash for another 12 months just might be the best move
1 Summary of Economic Projections. (2022, December 14). The Federal Reserve. https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf
2 Federal Debt and the Debt Limit in 2022. (2022, November 16). The Congressional Research Service. https://crsreports.congress.gov/product/pdf/IN/IN12045
3 Credit Research Outlook: Ready for a Cyclical Downturn. (2023, January 10.). Peter Hajjar, State Street Global Advisors. https://ssga.com/cash/insights/ready-for-a-cyclical-downturn
4 SEC Proposes Amendments to Money Market Fund Rules. (2021, December 15). The U.S. Securities and Exchange Commission. https://www.sec.gov/news/press-release/2021-258
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