As December brought to a close a brutal year for risk assets, not least for sovereign rates and credit markets as a whole, we saw a continuation of the rally in credit spreads that started after the darkest moments of September and October.

Inflation rates now appear to have peaked in the major developed economies as the biggest contributors to the spike that we suffered, energy prices, have fallen back to levels not seen since the start of 2022 or the backend of 2021. It might be fair to say that a mild winter has enabled Europe to dodge a bullet, and over-reliance on the wrong sources of energy has been corrected remarkably quickly with new supply lines in place, although the UK still has the least, almost negligible, ability to store gas.

China’s unexpected relaxation of COVID restrictions has the potential for upward pressure on crude oil prices and global inflation, but also on global growth. Sadly, the most immediate effects are likely to be felt by its oldest inhabitants following China’s woeful vaccination efforts.

The Federal Reserve remains determined to hike rates until inflation is firmly under control, but with the target rate already at 4.5%, amidst all the chatter and counter chatter from different voting and non-voting members, it does look as though the terminal rate is within 1% now. But it is also likely to stay at that level for longer rather than see a ‘pivot’ from the Federal Reserve as many seem to expect. US inflation rates continue to fall back, recent CPI numbers were in line but still down to 6.5% (disappointing for some), markets might also have to get used to this rate remaining above target for an extended period.

Quantitative Tightening (QT – the process of selling back some of the huge quantities of bonds that they have purchased over the past couple of years) continues in the US. But in the context of the Fed’s balance sheet being sub $1tn in 2008, peaking at $9tn in March 2022 and now at $8.5tn, they have barely started this process.

The European Central Bank, having left it the latest to start their hiking cycle, reduced their last hike from 75bp to 50bp but look to continue at this rate for the foreseeable future. President Christine Lagarde made a special effort to emphasize that further ‘significant’ 50bp hikes were coming. The ECB also announced that QT was starting in March, initially by not reinvesting maturing bonds to a tune of €15bn a month, in a (small) effort to tackle its €5.2tn balance sheet. Inflation did fall back more than forecast due to the aforementioned reduction in energy prices, but the ECB has to work hard to regain credibility.

The last member of the negative-yielding debt club has left, i.e. there are no longer any negative-yielding bonds out there, down from a high of $18tn at the end of 2020, a period that remains baffling to many, especially us. We are pleased to say that we could never understand the incentive for paying a borrower to lend them money. Two-year German Government bonds started the year with a negative yield (-0.08%) and are now yielding 2.6%.

In a surprise move, the Bank of Japan joined in with an unexpected announcement ending their negative rate policy and shifting their ‘yield curve controls’, a tip towards increasing their rates. They have been buying Japanese Government Bonds for decades to try and combat deflation and now own over half the country’s outstanding debt.

The Bank of England has regained some collective credibility (although the Governor is still capable of putting his foot in his mouth), and to a fanfare, they managed to unwind their emergency Gilt market LDI long-end support facility, commenced in September, at a profit. They bought £19bn of Gilts during the worst of the volatility and have sold them for a £3.5bn profit. This sounds satisfactory, but not when looked at in the light of the rest of their balance sheet that they are attempting to unwind (they bought £875bn of Gilts between 2009 and 2021), which has already cost them £11.5bn and might cost up to £130bn.

From the perspective of sterling, the surreal events of the muppet show mini budget chaos are thankfully fading into the past UK Credit Default Swaps (ie the cost of insuring against default by UK plc) have halved from their end-September peak. We are likely on course for a terminal rate of 4.5% for UK Base rates. Sterling credit spreads continue their rally but still offer value for good quality names. Recent GDP numbers show the UK economy escaped recession in 2022, much to the chagrin of some commentators.

The full Quarterly Review is available here. 

January 2023

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