SA Fixed Income Quarterly Insights | Quarter 3

13 September 2023

The 2023 Rugby World Cup, kicks off in France on September 8 (https://www.rugbyworldcup.com/2023/matches). Fans await a thrilling spectacle that will bring together rugby enthusiasts from around the globe. The Springboks can bank on facing intense competition and get an opportunity to showcase their exceptional skills and determination against the world's top rugby nations. Fierce rivalries will be in attendance and nail-biting matches are scheduled where fans will be treated to a feast of rugby excellence. Throughout the tournament, memorable moments will be etched in rugby history. From breath-taking tries to stunning tackles, the players will display their exceptional talent and commitment to their respective teams. What has been equally exceptional this year has been the remarkable resilience of the US economy despite a scare in 23Q1 stemming from stress in the US regional banking sector coupled with the vast extent of Fed policy tightening.

Following two respective 25bp hikes by both the Fed and ECB at their July meetings, investors are assessing incoming data to make judgements on if the door remains open for further hikes beyond September. The recent spate of weakness in both Chinese and European economic data is evident. If it turns more protracted it could sway DM central banks to finally signal they intend to, or are preparing to transit to an extended rate pause, following the rapid hiking cycles that commenced in 2022. High policy rates feed into borrowing and refinancing costs which together with more slack in the economy will serve to lower inflation which still remains elevated relative to central bank targets. Inflation breakevens which reflects forward looking inflation expectations have moderated considerably and their current levels indicate that the market has confidence that central banks maintain credibility to achieve their inflation targets in the coming 9-12 months.

Recent Fed minutes have revealed less unity amongst Fed voters on the path forward. New York Fed President Williams, Bostic are some recent speakers indicating they are comfortable pausing with Fed Chair Powell comments encouraging that the transition could be in the offing. A number of Fed officials are still commenting on the fact that inflation is still too far above target and that the US labour market remains tight which may require additional hikes.  Jackson Hole Symposium this month confirmed the Feds commitment to its 2% target but did not offer any explicit guidance for upcoming meetings. Upcoming speeches by Fed speakers will be parsed to better understand any shifts within the Fed camps which can validate the markets pricing for Fed policy easing to start next year around May. Cuts priced by markets may be either premature or too optimistic in terms of its quantum. As at the time of this article Fed futures are pricing in excess of 100bp of rate cuts out to the end of 2024.

By far the most relevant statement Powell came up with at FOMC July was: ‘’You start cutting your way to neutral rate before you get to 2% inflation'' and ‘’The Fed sees inflation around 2% beginning 2025’’. This is the first time he somehow validated market pricing for 2024 cuts, but most importantly he revealed a lot about the Fed’s reaction function: if core sticky inflation keeps printing weak, the Fed won’t be super orthodox about tight policy and start cutting in (possibly early) 2024. Supercore inflation (Powell’s preferred core services ex-housing indicator) has dropped from a 6-month annualized rate of change of 5.3% in February 2023 to 2.9% in July – that’s quick and means it is now at a level consistent with this same measure pre-2020 pandemic era. Should this disinflationary trend be sustained, in order to avoid policy being unnecessarily tight the Fed will be considering cutting rates. The question is how long it will need to be in a holding period. We know historically the Fed has kept the Fed Funds rate at the peak terminal rate for an average of around 9 months before delivering its first rate cut.

This would likely put us in the second half of next year assuming US economy cools (but avoids a hard landing) and inflation slows to near target. However a full year of disinflationary data until Q1 2024 seems like a reasonable yardstick, and Powell has now opened the door to cuts in 2024. This seems to be backed up by a recent Washington Post interview article with New York Fed President Williams when he answered questions about r* (neutral real policy rate) and indicating that policy rate setting my need to be adjusted lower in 2024 as inflation falls and the real policy rate rises (https://www.nytimes.com/2023/08/07/business/economy/john-williams-new-york-fed-transcript.html)

Chart 1 – US Treasuries sensitivity to growth as a driver has increased in recent weeks compared to inflation that dominated the discourse for most of 2022 and initial months of 2023        

Source: Bloomberg, Morgan Stanley Research

March 2024 might be the first live Fed meeting for a cut in our view given the current dynamics. Until such time as markets gain more clarity that central banks are ready to embark on an easing cycle, we anticipate that the growth outlook and how they diverge or coalesce in the US, Europe and China will prove to be more influential in the path of assets markets in the coming quarters than immediate policy action decisions or inflation dynamics. One illustration of this is the sensitivity of US 10y yields to both variables with bonds benefitting from disinflation this year after the 2022 inflation scare, but in recent weeks growth has played the dominant role. (Chart 1)

We continue to monitor the growth story closely and still prefer to position cautiously as US growth exceptionalism theme which is presently in vogue remains USD supportive and puts an upward bias on US yields. Likewise if our base case unfolds that expects a slowdown in US growth for a mild recession in US starting anything from December this year to 2Q24 based on past lag relationships of when US growth is impacted following policy tightening above the neutral rate (Chart 2) a more defensive positioning will be prudent.

Chart 2 – US Fed Funds have moved above r* since around December last year. Historically US economic weakness becomes evident 4-6 quarters after policy becomes restrictive (policy rate above r* neutral rate) which points to 24Q1 downturn. But risk is that a slowdown could be deferred with large US fiscal impulse obscuring the true underlying resilience of US economy to Fed Policy

Source: BCA

If we think about how quickly Fed policy affect the economy (Chart 2) help us in this regard. It takes a while and how long it takes really varies. The number of months between the first rate hike and the recession has varied with an average of 2.5 yrs. If you look at the hiking cycles and look at when the policy rate (Fed funds) starts to move above r* (equilibrium rate) we can see this points to on average 12 months before the economy feels the hard landing effects of this “tightness” in policy. The BCA estimate suggests that Fed funds moved above r* in December last year which indicates that if this cycle is similar, we can anticipate the recession or meaningful slowdown to start somewhere between December this year and Q2 next year. We don’t have a very high degree of conviction around this since there is also evidence that the transmission mechanism in this cycle is very slow as the US economic exceptionalism is also classified as beholden to the “Rasputin effect”.

Why has the US economy performed better than expected?

The US has mostly fixed rate mortgages now versus 2008 when there were far more variable rate mortgages. Corporates in 2020 went out and borrowed a lot and locked in very cheap funding rates. We include a link on a elucidating article elaborating on the US economic resilience despite 500bp hikes by Fed (The Rasputin Effect: Global resilience to higher rates). The mention of Bidenomics and Industrial Policy, Chips and IRA (Inflation Reduction Act) and the running of the largest US post-war, non-recessionary fiscal deficit on record are explanatory factors together with low financing costs at a 60yr low for US corporate sector are all standouts. Given the fiscal impulse the resilience in growth makes sense but most US economists expect this positive fiscal thrust to wane and turn into the opposite direction into 2024 resulting in moving from a mega boost to a net drag to growth.

Two key risks we are monitoring closely for a shift in market sentiment are due in just over a month from now. This includes a possible US Government shutdown as well as the lifting of the moratorium on Student debt payments in the US. This will mean over 40million americans will have to start paying an average of $200-300 per month again to service this debt. This is a huge loss of purchasing power at a time when the Fed’s 5.25% interest rate hikes are starting to weigh on the economy. The White House estimated this cost to be 0.3% of GDP, but it is likely closer to 0.5% of GDP. Excess savings by households bult up during the pandemic period is now approaching run-off and close to a level of depletion by many estimates once we enter 2024.

How do we view SAGBs and what could shift our thinking?

Considering a scenario where US growth slows but only mildly (a recession is avoided) combined with a strong fiscal stimulus in China and a start of a Fed easing cycle, we would anticipate in the medium term that emerging markets including SA bonds and ZAR will perform very well and hence remain vigilant to shift our own exposures if current conditions change more favourably to align with this scenario.

However, several domestic factors that keeps us defensive on SA bonds. One such factor is a shortfall in revenue collections and some additional spending on the wage bill front that raises the risk for additional SAGB and ILB issuance post the October MTBPS. Intentions around launching an NHI that will be an unpalatable burden on the fiscus and debt overhang of municipalities are issues that poses risk to the sovereign balance sheet if we look beyond the MTEF (Medium Term Expenditure Framework) at a time when the commodity cycle is no longer accretive from a corporate income tax take perspective. Recently National Treasury also announced monthly switch auctions that kicked off in August and lasting through to March 2024. Although these will involve cross asset switches (linkers for linkers, nominals for nominals or linkers for nominals and nominals for linkers) we anticipate that large cares for switching R2030s will imply that this bond will be one of the main features in upcoming switches and into the next fiscal year. Larger auctions sizes at a time when bid/cover rations are waning, and local banks and institutions are already carrying a heavier burden towards funding government are aspects that lead us to anticipate the curve to steepen further or remain steeper than in previous SARB cutting cycles.

Since our Q2 Insights piece (published late March) where we expressed a view to own and overweight R2030 FX-Hedged in portfolios versus an ALBI weighted benchmark portfolio and with a bias to express larger duration in the front and belly of the curve. This positioning has outperformed ALBI over the period by some 400bp over the past 5 months. We continue to advocate this positioning together with R186/2048 and or R2030/R2048 steepeners until fiscal slippage risks and switch auction dynamics are better priced. Alternatively, for long-only investors we would continue underweight long and ultra dated bonds and focus on R2030 and the belly that can perform well as the market adjust its views towards SARB rate cuts from end Q1 2024 with March meeting being a live meeting for cuts in our view.

Markets have been trading two major themes lately: US resilience and China challenges. While these have mixed implications for other asset classes, in FX they both tend to mean one thing—a stronger Dollar. Given our upbeat view on US activity (note economists has revised up their Q3 GDP tracking by over 1.1pp over the month). We don’t think relief will come from the US side in the very near term. That could happen eventually, if the market gets more comfortable that disinflation can continue despite strong growth, but investors seem sceptical that can be durable. And it is worth noting that Fed policymakers felt the same way, according to the July meeting minutes. Chair Powell’s speech at Jackson Hole this year did not carry the same ‘pain’ warning as last year, but the overall message was one of “seeing the job through,” and the Fed still thinks that likely entails a period of below-trend growth, which has clearly not been achieved yet. Therefore, a break in the Dollar likely has to come from a positive turn in China and Europe. A more forceful policy pushback could provide a temporary interruption, like it did a little less than a year ago. But, the most plausible path to more substantial Dollar downside involves better growth in Europe and Asia alongside continued disinflation pressures in the US, and the path to that combination has been narrowing again. Almost three-quarters of the way through 2023, we are still ‘waiting for the challengers’ to step up convincingly.

US economic surprise momentum has been remarkably strong since June and is yet to show signs of abating on an aggregate basis which has resulted in pushing up US bond yields as investors give higher weighting to the possibility that the US economy could escape the much-anticipated recession (Chart 3). Leading indicators and Yield curves have prognosticated elevated probabilities of a US recession for 23H2 that has been visible and enduring in indicators and models since its appearance in late 2022, yet for investors the extent of US disinflation in 2023 and the resilience of the US economy, despite interest rates moving up 500bp in just over a year, has been confounding. Three out of Four fund managers surveyed in the most recent Bank of America (BofA) FMS survey now expects a US soft landing and cash levels is lowest since Feb 2022 which tells US that investor optimism has improved that we may near or close to and inflection in the US business cycle (using ISM Manufacturing as a proxy).

Chart 3 – Positive Growth surprises in the US have outweighed progress made on inflation in recent weeks to push yields closer to cycle peaks seen in October 2022. As upside growth surprises start to wane (cyclical factor) we anticipate it will allow for a partial unwind of the recent backup in US bond yields by latest 24Q1. Risk to this view includes longer than anticipated QT pushing up up US term premium and the Fed maintaining policy rates at elevated levels into 24H2.

Source: Bloomberg

A Summer of Surprises

August is often a month associated with Northern Hemisphere Summer Doldrums and thin mkt activity and liquidity. But since the outset of the month the moves seen in US bond market resulting from US 10yr and 30yr yields rising faster than US front end 2y yields have certainly presented us with a lot to think about as far as yield curve outlook is concerned. The saying goes that bad news comes in 3s and earlier this month we had multiple factors that coalesced, to drive curve steeper. These were (1) The US refunding announcement for the quarter that raised concerns about increasing supply of bonds involving larger US bond auctions sizes, (2) Fitch ratings agency downgrade of US debt rating from AAA to AA+ and (3) The Bank of Japan (BoJ) YCC (Yield Curve Control) Policy tweak.

This development of the BoJ yield Curve Control Policy tweak signals they are willing to adjust policy to be slightly more restrictive in allowing JGB yields to rise gradually which can be seen as an incrementally hawkish development for global bond markets. Japanese investors have embraced buying foreign bonds in EM and DM in the past 10-15 years at an increased rate and may trim their holdings to repatriate funds as JGB yields rise and Japanese Yen finds a more stable footing vs USD. The fact tat the BoJ is not only explicitly committing to buying 10y JGBs at 1% we remain vigilant to risks in global bond markets if BoJ signals additional moves which is not our base case for the Summer months but could feature again later in 2023.

As we move forward the main focus for global investors will be on the Fed getting closer to the end of its tightening campaign and seeking confirmation that this has occurred. We opined in our previous Insights article that we are looking for DM central banks to also transition to a point in Q3 when they will reach their terminal policy yields in their hiking cycles. This seems very much on track for now with possible exception of the UK where inflation remains far above its DM peers. Overall we have seen the global disinflation trend gain traction as we expected which we wrote about previously. On this front, outside of DM the Latam region remains some ways ahead of other regions with scope to start their easing cycles soon which makes Latam rates such as Brazil and Mexico attractive to have exposure to that can produce strong USD hedged returns in the coming 6-12 months.

The key question from investors is whether that means the Fed has orchestrated a soft landing or if a recession is unavoidable. While many investors remain sceptical of the soft-landing outcome, equity markets have traded so well this year that these same investors have been swayed into thinking a soft landing is now the highest probability outcome. We believe equity markets are in a classic policy driven late cycle rally. Furthermore, the excitement over a Fed pause has been supported by very strong fiscal impulse and a still supportive global liquidity backdrop, even with central banks tightening. The latest example of a similar late cycle period occurred in 2019. Back then, a robust rally in equities was driven almost exclusively by valuations rather than earnings, like this year. Both then and now, Mega- cap growth stocks were the best performers as equity market internals processed a path to easier monetary policy and lower interest rates. The 2019 analogy suggests more index level upside from here, however, we would note that the Fed was already cutting interest rates for a good portion of 2019, leaving ten year Treasury yields 200 basis points lower than they are today. Nevertheless, equity valuations are 5% higher now than in 2019.

The other scenario is that we are in a new cyclical upturn and growth is about to reaccelerate sharply for both the economy and earnings. While we're open minded to this new view materializing next year, we'd like to see a broader swath of business cycle indicators inflect, higher, breadth improve and short term interest rates come down before adjusting our stance in this regard. In other words, the current progression of these factors does not yet look like prior new cyclical upturns.

Meanwhile, US Q2 earnings season has been a fade the news so far, with the average stock down about 1% post results. This is worse than the past eight quarters where stocks are flat to up. While hardly a disaster, we think companies will have to start delivering better sales growth to outperform from here. On that score, even the large cap growth stocks have been mostly cost cutting stories to date. Another interesting observation over the past month is that the worst performing sectors are starting to exhibit the best breadth of performance, namely energy, utilities and health care. Industrials is the only leading sector with improving breath. Given the uncertainty there remains about the economic outcome in central bank policy, investors should look to the laggards with good breadth for relative performance

Macro Conditions in China remain challenging and clouds the EM outlook while Fed is in an extended pause

Economic growth in most EM countries has been resilient in the face of aggressive monetary tightening, likely on the back of China’s initial post-Covid recovery and very robust U.S. growth. Looking ahead, the EM outlook faces challenges from macro conditions in China and the U.S. To turn more bullish on EM, we will need to see evidence of decisively reflationary policy thrust from China and a sharp enough downturn in U.S. economic momentum to trigger a dovish Fed pivot. Our current read on President Xi and Chinese policymakers is that the bar remains high for a bazooka style stimulus. We also assign higher probability that consensus to a drawn out period where more painful rebalanding is needed before we may see forceful stimulus being delivered in China. Both conditions (namely Fed and China) are currently absent. In this environment, EM equities will likely struggle but local currency government bonds should outperform. 

Talk of recession, soft landing or no landing may miss the important reaction function of the Federal Reserve. In the past half century, the Fed has been slow to react to upturns in inflation, but quick to respond following employment peaks. If the monetary-policy reaction function remains similar, any economic slowdown would have to include an expectation of or actual job losses and lower inflation for the Fed to consider cutting rates in absence of financial stability risks. Given the uncertain and varied expectations for economic activity later this year and next, the market is currently pricing for the midpoint of two federal funds rate paths -- unchanged or deep cuts. We concur with the RMB houseview outlook that the Fed is done this cycle. This houseview shows US economic data will show moderating inflation and slower economic activity as we move from Q4 into 24H1.

What kind of Fed easing should we anticipate and what is being priced?

As the economic picture evolves it will become clearer if the eventual Fed easing will be more of emergency step to address a sudden weakness in the financial system as long and variable lags and fading US fiscal impulse wear off causing a sharp and sudden economic retrenchment or will it be more of a gradual, well-telegraphed action?

Though linear markets such as federal funds futures, overnight index swaps, and SOFR futures are pricing for the Fed to cut rates about 1% from current levels by the end of 2024, options on SOFR futures present a less certain view. If the market was "certain" of the 1% cut outcomes, the distribution of delta-weighted options of SFRZ4 should present as relatively normal, yet it doesn't. In fact, there's twice as much out-of-the-money put delta as out-of-the-money call delta for SFRZ4 (SOFR Dec-24). We think this partly reflects a belief that the Fed will be on hold for much longer than linear markets are pricing.

Investors need to remember that linear products, like Fed Funds futures, price a weighted average of expected outcomes, and don't represent a full distribution of risk.

Chart 4 – Delta Weighted SOFR Dec-24 Calls/Puts

Source: Ashburton, Bloomberg

The Rugby World Cup Awaits

As ardent Spingbok supporters we back our team to deliver an outstanding performance, reaching the final and captivating the crowds crowd with their flair and tenacity on the field. Ultimately, it remains to be seen if the Springboks can reach the finals and emerge victorious to clinch their 4^th Rugby World Cup title. If so it would solidify their position as one of the sport's powerhouses. Current odds according to Hollywoodbets indicates an implied probability of Springboks to win this years Rugby WC final in late October at near 20%. This is quite a far cry below the implied odds of a US recession according to New York Fed’s measure to occur in the next 12 months as well as the Bloomberg proprietary model forecasts assigning high probability of a US recession starting between 23Q4 and 24Q1.  (Chart 5)

 (https://www.newyorkfed.org/research/capital_markets/ycfaq.html#/interactive)

Chart 5 – Bloomberg Probability Models of US recessions in the coming 6 months derived from US 3m/10y and 2y10y yield curves and 13 US Macro Variables vs Past US Recessions

Source: Bloomberg

There are good reasons to be more optimistic about the prospect of a soft landing, based on recent data based and the enduring resilience we have seen in the US. Earlier we discussed some factors that have contributed towards this unexpected outcome. However, we don’t find these reasons persuasive enough at this time that the current cycle is different from past aggressive Fed tightening periods to change our baseline of a recession in early 2024. As Springbok supporters we would favour better odds of a world cup win, yet as investors prefer to trump the odds of a late 2023 or early 2024 US economic slowdown (hard landing outcome) by adopting a more risk averse stance in general and having a bond over equity tilt in balanced portfolios. The convergence of yields across asset classes seems to support this view (Chart 6)

Chart 6 – Convergence of Yields Across Asset Classes

Source: Bloomberg, JPMAM, 21 July, 2023

Parting Thoughts - What happens if the US economic recession is averted?

Past US recessions have thought us that SA and EM bonds since as SAGBs face a lot of headwinds (as spreads to US widen) and is typically associated with a bout of sharp ZAR depreciation. Given the fiscal risks and higher issuance we prefer owning belly bonds (e.g. R2030 to R2035 strip) on an FX hedged basis for levels of USDZAR <18.50 for new trades (initial engagement was around 17.50 in March). FX fair value model using interest rate differentials, Debt/GDP and Commodity Terms of Trade for SA with forecasts suggests USDZAR fair value closer to the 19.45 area into end 23Q4. We acknowledge however that Chinese yuan intervention that is underway now to defend the CNY/CNH at 7.30 area together with China policy action news or lack thereof will play a large role if ZAR will continue its depreciation path or not. We keep an open mind to the possibility of a US soft-landing outcome to manifest as fiscal impulse from Bidenomics continues to bolster the growth outlook but will need to see more evidence of a decisive upward turn in many leading indicators to adjust our investment strategy meaningfully.

What happens if the US economic recession doesn’t happen? For us this remains a tail risks scenario rather than our base case view, but it will most likely imply that interest rate markets continue to price rates staying higher for longer and price out future rate cut scenarios. This would most likely see continued bear steepening of yield curves if economic resilience persists. Stated differently we would see more of the same we have seen in recent weeks with rising term premiums being priced into longer dated bonds. (Chart 7) One play that can perform in both outcomes on either curve bull or bear steepening is STPU [Lyxor US Curve Steepening 2-10 UCITS ETF] that also serves as a portfolio hedge if the curve becomes a bull steepener in a late cycle risk-off episode.

Chart 7 – An increase in Treasury Duration earlier this month suggested US 10y Term premium could increase about 50bp. We have witnessed most of this adjustment already happening in the Aug UST selloff

Source: US Treasury, Deutsche Bank

As the 2023 Rugby World Cup promises to be a celebration of athleticism, sportsmanship, and deliver the memory of the unifying spirit of rugby. We believe this year from an investment perspective may also carry the memory playing out as a multi-faceted one. We anticipate a period where the AI theme led bullmarket emerged after a US regional banking sector jolt, amids a disinflationary episode could morph into a reality check correction as the eventual economic slowdown arrives.
If this transpires it prepares the way to transition to an environment where global central banks again adopt a monetary policy easing cycle in 2024. This transitional journey will shape the investment landscape in the coming quarters.