Capital Ideas^TM

Quarterly macro and market insights from Capital Group’s fixed income team

Yields rise to attractive levels, though headwinds to growth loom
 

• Volatility likely to continue as uncertainty remains high
• Much higher inflation may keep the US Federal Reserve (Fed) on tightening path in near-term, even as growth weakens
• Global growth backdrop is deteriorating, particularly in Europe and China

Sharp shifts in expectations for central bank policy and the resultant market volatility underscore the challenges facing investors. The third quarter featured a tale of two halves: An initial rally across markets turned into a sell-off. Hopes for less restrictive central bank policy were dashed by higher-than-expected inflation data and more hawkish central banks globally. Interest rates rose, credit spreads widened and equities fell broadly in August and September. Wide trading ranges in global interest rate markets in particular reflect the swings in prevailing expectations for central bank policy. This volatility is likely to continue as uncertainty remains high and growth momentum slows globally.

Fiscal developments in the UK in late September exacerbated the volatility in markets. A plan from the new UK government to add fiscal stimulus sent interest rates soaring and the pound sterling plunging. Within days of the announcement, short- and long-dated UK gilts rose over 100 basis points (bps), prompting an emergency bond-buying operation from the Bank of England to help counter a liquidity crisis for the country’s pension plans. Global rates in turn followed UK gilts higher while risk assets struggled.

Central banks globally re-affirmed a commitment to reducing high inflation. The Fed and many global counterparts pushed back on the market’s initial expectations for less aggressive monetary policy.
Fed Chair Jerome Powell delivered successively hawkish messaging on the committee’s focus to slow inflation. Two large 75 bps hikes during the quarter brought the policy rate just shy of 3.25%. The European Central Bank also delivered large (50- and 75-bps) hikes while central banks in Canada and Sweden each surprised with a 100 bps hike. The synchronised rate increases underpin a broad tightening in financial conditions that we expect to continue. With market expectations for Fed policy rates to now peak over 4%, pricing of front-end yields looks reasonable. 

Inflation remains stubbornly high. Even as the overall rate has shown signs of potentially peaking, underlying trends indicate much more broad-based inflation. Measures that focus on “stickier” elements of inflation remain elevated. Additionally, wage growth has accelerated, raising the potential for inflation to remain at elevated levels. While inflation will likely decelerate over time from today’s high levels, markets may be underestimating the time it may take to reach levels more acceptable for the Fed. This will likely keep pressure on the Fed to remain on its tightening path, even as growth conditions worsen.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.