This data captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10% of outstanding fixed income securities globally.
For the better part of the past year, monetary policy has been straightforward. High inflation required higher rates — and there was little debate about that. Market surprises were generally to the upside, as central banks unleashed jumbo hikes not seen since the 1980s, if ever.
This one-way street to higher yields grew more complicated when policy crossed into restrictive territory, and the long and variable economic lags became shorter.
Q2 saw a growing disparity among global central banks, with skips and pauses from some and sizable hikes from others. Timing matters, and those who came late to the tightening cycle are expected to remain the most active through the end of the year. Many central banks brave enough to pause their tightening have been pulled back into the fray, as inflation proves to be a stubborn adversary.
G-10 central banks hiked rates a total of 475 basis points (bps) in Q2, with at least one hike from each bank, excluding the Bank of Japan. The cadence of hikes accelerated toward the end of the quarter, with June seeing the most activity as several central banks returned from their rate hiatus.
Market pricing now expects another 500 bps of hikes across the G-10 before reaching terminal — a significantly more aggressive path than was estimated at the start of the quarter. With every central banker pushing the higher-for-longer message, there’s also been a dovish shift in rate cut expectations.
Stronger than expected economic activity contributed to the more challenging inflation profile, which has also pushed back against fears of an imminent recession. And while our Recessionary Likelihood Indicator remains unchanged at 55%, the emerging view is that recessions are now a concern for 2024, with a growing hope that we’ll see only mild slowdowns this year.
Recent disinflation in online prices may provide central banks some breathing room if PriceStats® trends broadly translate into official data. This will further support the view that we have moved on from the wishful thinking at the start of Q2 and are truly close to the end of the tightening cycle.
This had led to strong flows into most global sovereign bond markets. But real money investors also have increased their cash levels as recessions appear delayed, not erased. Interest in the US Treasury Inflation-Protected Securities (TIPS) market has also moderated, supporting the view that inflation will become less important as we near the end of the tightening cycle. Lastly, most of our credit flows are negative, indicating that the recent risk rally is proving too aggressive given ongoing recessionary concerns.
It’s been a tumultuous period for bonds, with inflation, aggressive central banks, and recession fears providing plenty of reasons to avoid both developed market (DM) and emerging market (EM) sovereign debt. And while we still don’t have clarity on any of these topics, yields have risen to sufficiently high levels to entice real money investors back into the markets.
We find that while peak inflation is clearly in the rear-view mirror, sticky inflation has emerged as an ongoing concern. This has kept central banks actively tightening, with several attempted pauses proving premature. So, while it’s safe to say that most global economies have exceeded expectations in the first half of the year, overall recession expectations remain elevated and continued rate hikes increase the risk of a policy mistake.
These concerns prove challenging for all debt investors, with recession risk and sticky inflation creating issues for both DM and EM bond buyers. It’s therefore interesting that our active institutional investor flows show buying across both of these markets.
Inflation swaps indicate that consumer price gains are expected to fall precipitously going into the end of the year, possibly as the lagged effect of policy tightening drives greater recessionary risk. This would explain rising DM inflows, although it would be counterintuitive to see EM activity rising. Positive real rates and continued uncertainty over the timing or strength of any recession are making the high yields offered by many local currency EM bonds an attractive bet at this juncture of the economic cycle.
The Federal Reserve (Fed) took a breather from its aggressive tightening campaign in June, with all voting members of the Federal Open Market Committee (FOMC) agreeing that the pause was necessary to gauge how the economic headwinds created by recent banking stress had evolved. Most members were strident in saying that they’d continue to tighten unless inflation quickly subsided, and their economic projections anticipated the need for another 50 bps of rate hikes this year.
Pricing around the June Fed meeting had already anticipated at least one more hike and futures markets are now giving a one in three chance that the last 25 bps hike will be needed. Economic data nonetheless remains mixed, with employment gains and improving consumer confidence making sticky inflation an ongoing concern.
Our real money investor flows into the Treasury market have remained near their highs over the past five years. With percentile ranked 20d duration weighted flows in the 96th percentile, investors are expressing a strong preference for the yield offered by longer-dated bonds that also offer downside protection in the event of a recession.
Inflation concerns also appear to be subsiding. TIPS flows have recently consolidated closer to neutral, indicating that fewer investors are seeking inflation protection.
For the first time since the Global Financial Crisis, cash yields are providing a reasonable return relative to risk assets. Granted, when adjusted for inflation, short-end yields continue to underperform. But in the face of economic uncertainty, cash yields have been gaining in appeal. And since the most aggressive Fed in a generation has been the primary catalyst, the path of policy rates within the economic backdrop will continue to define cash’s attractiveness.
Our data indicates that overall investor asset allocation to cash generally increases heading into a recession, as ultra-short investments provide shelter during these storms. The Fed also may not be done hiking, with current FOMC projection expecting another 50 bps of hikes before remaining at a 5.625% terminal level for up to three quarters. The highly anticipated cutting cycle is also expected to be gradual, with only 100 bps of rate cuts projected through end of 2024.
This higher-for-longer mantra goes hand in hand with expectations that it will take longer to tame stubborn inflation. This backdrop has pushed overall cash allocations to their highest levels during the current tightening cycle, with the 19.5% cash allocation near 10-year averages.
Furthermore, the yield advantage that money market funds enjoy over banks deposits may keep this cash weight on an upward trajectory, as investors are essentially being paid to park assets within the money market complex.
Inflation is an overall increase in the prices of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
Important Risk Discussion
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Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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