RBC BlueBay: Cash is king

March 10, 2023

Short-term rate expectations continued to rise during the past week, following a hawkish Congressional testimony by Jay Powell. In the wake of this, markets have moved to price a 50bp March hike as a central premise, though ultimately this will depend on upcoming data over the next several days. Ostensibly speaking, it appears that the Fed is in the process of concluding that rates will need to go higher for longer, in order to slow the economy and ensure price pressures are brought under control.

From this standpoint, it appears that ‘no landing’ for the economy is not a sustainable outcome and that either we will either witness a ‘soft landing’ or a ‘hard landing’ in activity in the months to come. By extension, this may mean that strong data now means higher rates to follow, and thus a greater chance of a ‘hard landing’ at a later point in time.

As a result, following on from a run of recent robust data, so long-dated yields have actually declined over the past week, even as two-year Treasuries breached 5%. This has left the yield curve at record levels of inversion, last seen under the Volcker Fed of the 1980s.

Typically, such an inverted curve would point clearly towards a ‘hard landing’ and might be expected to lead to pressure on risk assets. Yet, rather than forward-looking economic pessimism, it seems that curve inversion is being driven in uber confidence that the Fed will be successful in returning inflation to its 2% target, with cash rates returning to a level just above this rate, in the course of time.

From this point of view, it seems that equities have continued to be supported by such an outcome, which suggests there is no need to alter perception of the discount rate, which should be applied to long-dated cash flows. However, in our eyes, we think that markets may be somewhat over-confident of the Fed’s abilities here. We are much less certain that the valuation norms seemingly established during the past decade will hold in the decade ahead of us, with a risk that inflation and cash rates end up staying somewhat higher than we have seen in the past.

In a sense, we think the Fed and other central banks will be hostage to the data. Consequently, we retain a cautious view on risk assets, at a time when we continue to expect growth to slow and interest rates to remain elevated for some time to come.

In this landscape, it also catches our attention that an index of US Investment Grade (IG) corporate bonds now only yields no more than cash deposits offer, as of the middle of this year. Cash is becoming king in a world of extreme curve inversion, and we see merit in an approach that can deliver absolute returns on a cash-plus basis.

Similarly, Euro IG credit benchmarks also offer yields not much above cash and until rate expectations can decline, we are struggling to see how longer-dated yields have much room to fall from here. This suggests merit in a relatively defensive allocation at the current time, even if going into upcoming payrolls and CPI data it might appear that there is now plenty of bad news already ‘in the price’.

In the past 24 hours, newsflow from Silicon Valley serves as an example of where we have thought caution is needed with respect to investments in private assets. As and when assets are marked to market, losses may be expected to accumulate in this space with the private equity industry slowly realising how dependent it has been on cheap money and leverage in order to juice returns. In discussions with policymakers, a degree of stress in this space is expected and we don't see anything to alter the Fed's path, unless losses act as a trigger for a much more broad-based tightening in financial conditions.

Notwithstanding a defensive bias, we would continue to note that, with the economy seemingly doing fine for the time being, so the near-term recession risk is relatively low. High yielding credit appears fully priced. However, technicals related to limited supply and low levels of defaults mean that a more tangible fear that we are heading towards a ‘hard landing’ may need to be seen, before assets re-price.

Meanwhile, there is a lure in the idea that investors can invest at yields close to 9% in absolute terms, noting that any such entry point in the past decade has proven a very attractive point to buy. Albeit, we see this narrative somewhat undermined by the fact that we are already pricing for short-term interest rates to rise to 5.6%, with a clear risk now that the Fed could hike to, and beyond, 6%.

In analysing economies, it remains clear that many US households have effectively hedged against higher rates, by refinancing mortgages at record low levels in 2021. Yet, in countries where consumers are directly impacted by rising borrowing costs, the outlook appears much more strained. This has been true in Sweden, where house prices have already fallen by 15%, and we think a similar narrative is set to impact the UK property market.

Up to this point, UK data have held up better than we would have expected. Yet inflation is elevated and wage inflation looks to be accelerating rather than slowing, thus driving second-round effects. However, with this meaning that the Bank of England will also need to continue to hike further (and notwithstanding a revealed desire not to do so), we project material weakness in the months to come. Against this backdrop we retain a negative view on gilts and the pound.

Meanwhile, a decision to maintain Yield Curve Control (YCC) at Governor Kuroda’s last monetary policy meeting has seen JGB yields decline overnight, with the yen somewhat weaker. Nevertheless, we remain confident in our expectation that policy will be adjusted by incoming BoJ Governor, Ueda.

Inflation is likely to continue to surprise to the upside and we have been interested by a push by Japan labour union, Rengo, for a 5% pay hike in the important annual Shunto wage round, which will conclude in the next few weeks. With companies such as Toyota already agreeing to meet union requests in full, so we think that the outcome of Shunto will be much higher than the 2-3% which other market participants are looking for.

We continue to maintain a short stance on Japan rates and have been using recent weakness in the yen to increase exposure to the Japanese currency. We see the yen as undervalued on a valuation basis and believe that an end to YCC could see the yen rally to 120 versus the dollar.

Elsewhere, higher US rates have seen the dollar rally, with the greenback now having reclaimed just over one-third of its losses during the fourth quarter last year. Generally speaking, we think that the dollar should trade with a negative correlation to risk assets, and in this respect, we continue to be surprised that we have not seen a more generic re-pricing of risk, as investors digest the risks of higher rates for longer and the prospects that this will lead to materially weaker forward-looking growth.

In rates, we continue to run a flat stance in the US and Eurozone, after closing shorts last week. At this juncture, we think that we are more likely to see bigger moves in the prices of risk assets, than in government rates, should upcoming data hold any surprise in store.

Looking ahead

Upcoming data represents an outsized driver of market volatility. Broadly speaking, we have thought that February data may remain strong in the wake of what we saw in January. However, it is possible that March releases due in April will look more benign. There is no doubt that recent activity has been flattered by very mild winter weather and also bullish sentiment in the wake of China re-opening.

However, these drivers are likely to prove temporal in nature. Reading and timing these shifts will continue to be important and macro considerations are likely to remain at the fore for all investors. In this case, cash may be king for a time (unless, of course, you’re the Qatari owners of Paris Saint-Germain). However, the notion that cash is king does not mean that it may not remain on the throne for very long….