BBVA take a significant step forward for AT1s
Markets navigated this week with relative calmness after receiving several important releases, including central banks’ monetary policy decisions and new projections on top of CPI data. I say ‘relative’ calmness because there were quite large moves in the short end of the bund and GILT curves which sold off in response to increased terminal rates expectations. In the UK the price action was heavily influenced by a very inflationary labour market report containing accelerating wage trends, while in the Eurozone the ECB came out with their new set of macro-economic projections which were considered to be hawkish by market participants. The US Treasury curve exhibited volatility but ended the week more or less at the levels of last Friday.
The ECB and the Fed raised and paused in line with markets expectations. However, their updates of macro projections included higher growth and inflation for the most part which means higher monetary policy rates than expected. A few quarters ago we would have expected this to have caused a relatively large market reaction with curves moving markedly higher and risky assets underperforming as a result. However, compared to last Friday’s close this time around the S&P is up 3%, the Euro Stoxx 50 is up 1.76%, US HY is up 0.44% while EUR HY and the Coco Index posted small gains as well. Is the market being complacent? Although there might be an element of that in certain asset classes, we think the muted or positive reaction also has to do with two factors.
Firstly, markets rightly anticipate that we are in the latter stages of the central banks’ hiking cycles. When rates are in the 5% region the marginal impact of changing assumptions from 25bps of additional hikes to 50bps is not as large as when rates are close to zero. Secondly, central banks seem to be firmly in the soft landing camp (the FED for instance raised their 2023 real GDP growth target to 1% and reduced their unemployment rate target to 4.1%). Although market expectations seem to be a bit more bearish than central banks’ (which explains why markets seem reluctant to price in the two additional hikes seen in the new “dot plot”) we have still seen growth projections move up by forecasters at the margin along with slightly more elevated terminal rates. That means a bit more resilience for company earnings, which in turn should make refinancing debt easier than otherwise. Ultimately, Jerome Powell emphasised that they remain very much data dependent, so it follows that if data is weaker than the Fed expects then the central bank will be open to softening their stance; but in the meantime they want to maintain their hawkish signalling to the market and stop any near term cuts from being priced in.
Time will tell if we actually have a soft landing. We are in the camp of a small contraction in GDP in the US, while we have already seen that scenario developing in the Eurozone in Q4 2022 and Q1 2023. If this is what actually happens and inflation continues to decline slowly but surely, then the outlook for total returns in a diversified fixed income portfolio look decent with yields in certain markets at their highest in 10+ years.