Deep Dive video – China and other inflection points (8:37)
Listen in to CIO's Eva Lee on key global opportunities right now.

Thought of the day

Strong retail sales data for January provided the latest indicator that the US economy is in better shape than many had anticipated, fueling expectations that the Federal Reserve will have to tighten further beyond the current quarter. At the time of writing, the federal funds futures market implied a peak rate of nearly 5.23%, up from 4.81% at the start of this month, and higher than the median projection in the “dot plot” suggested by the US central bank in December.

Treasuries sold off following the release of the data, with the US 10-year yield rising 4 basis points to 3.8%, the highest level since the start of this year.

We acknowledge the likelihood of the Fed raising their growth forecasts and the projected rate path trajectory at the next FOMC meeting in March, given the tight labor market and still-elevated inflation. But we also maintain the view that bond returns will recover this year.

All-in yields remain appealing, particularly relative to opportunities in other asset classes. Aggressive central bank tightening last year contributed to a sharp rise in rates, leading bond yields to levels that were last seen more than 10 years ago. For example, while the yield on the 10-year US Treasury is down from a peak of 4.23% in October, it remains close to the highest level since 2010. Initial yields are generally a good indicator of subsequent long-term returns for bonds.

Interest rates are unlikely to go much higher despite volatility ahead. While investors have scaled up the implied peak in fed funds rates in recent weeks, we think this was in part because markets had moved too quickly to expect a dovish pivot from the US central bank. Fed officials have stressed that more needs to be done to curb inflation. But the pace and scale of additional rate hikes are unlikely to match those of 2022. The 425 basis points of tightening implemented last year was the fastest since the start of fed funds targeting in 1982. Overall, we take comfort from the fact that many central banks have succeeded in restoring medium-term inflation expectations at or near their target levels.

Inflection point in inflation is likely just delayed, not derailed. While US inflation may not have moderated as quickly as expected and economic activity has held up better, we still see price pressures easing through 2023. With the lagged effects of last year's rate hikes still feeding through into the economy, we also expect growth to slow. The lackluster fourth-quarter earnings season reinforced our view that tighter financial conditions are starting to take their toll.

So, we continue to see a favorable outlook for fixed income markets in 2023, rating high grade and investment grade bonds as most preferred amid slowing growth. We also think select short-duration bonds remain in a sweet spot for income-seeking investors, especially for those with limited risk appetite currently. Finally, we like emerging market bonds as China’s reopening and increased support in the property sector should be a tailwind for the asset class.