- Central banks can take a break
- The negative relationship between stocks and bonds can flare up
High interest rates and wide expansion of credit spreads are a combination not seen in a long time. Central banks have repeatedly raised interest rates and tightened monetary conditions in an effort to control inflation. At the same time, it increases the risk of an economic downturn, which leads to an increase in risk premiums. In such a world, duration and credit risk are positively correlated, and when interest rates rise, credit spreads widen.
We believe that fixed income will return over the next 6-12 months as markets are likely to finally gain more certainty about the peak of the central bank rate hike cycle during that period. We have already seen some attempts by the markets to pinpoint these peaks in 2022, but so far they haven’t had much success. So the outlook for fixed income should be very good on the 12-14 month horizon, although the issue, of course, is the timing of the turnaround.
Inflation remains unchecked and, perhaps more importantly, inflation is widening, particularly in the US where wage growth is a major concern. This will keep central banks on their toes for some time to come, and encourage them not to be complacent in their monetary policy. At the same time, central banks realize that they have already jolted economies to some degree with the interest rate increases that have already occurred. The Fed raised interest rates four times in quick succession by 0.75%. With interest rate changes affecting the economy with so much delay, it is not farfetched to think that central banks will take a break to assess developments in their economies. However, they also need to consider what markets and economic agents are implicitly telling them, that they need to be active to maintain confidence in their inflationary mandate. Ultimately, that confidence is more important to central banks than the added risk of tipping economies into recession. However, we think markets in Europe (including Norway) have already priced it in with enough confidence. Even more mysterious is what it will take to get the US economy back on track, where wage pressures are strongest.
We believe that 2023 will be a year for bonds, not a year for stocks. It could even be that the well-known negative relationship between bond and stock yields is recovering. At least the probability of that happening has increased with higher interest rates.
By Svein Aage Aanes, Head of Fixed Income at DNB AM
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