A Peak That Persists

We think sticky services inflation paired with a moderate slowdown will enable central banks to maintain higher rates for longer.

During 2022, some of the biggest moves in global markets occurred on the days when U.S. Consumer Price Index data were released, so it’s no wonder last Thursday’s numbers were so hotly anticipated.

Year-over-year headline and core inflation chimed with the consensus expectations. We got another reassuring month of steady declines.

The underlying mix of inflation differed somewhat from expectations, however, and was perhaps less encouraging.

Benign

Investors liked the November data, released a month ago, which appeared to show inflation easing quite broadly.

In December’s data, we continued to see month-over-month cooling, and even some accelerating deflation, in most food, energy and goods prices. But services inflation picked up again, reminding everyone that these price hikes have tended to be the stickiest in past inflationary cycles.

The immediate market response was as mixed as the data.

An initial, sharp tightening of financial conditions was quickly reversed, giving way to a more sustained loosening, with equities rising, yields declining, the dollar weakening and the price of gold rising. After a few hours, investors had chalked this up as another relatively benign set of numbers.

Fed Messaging

Adding complexity to the picture were comments from Philadelphia Federal Reserve President Patrick Harker that paired a willingness to slow rate hikes to 25 basis points with a determination to keep implementing them until inflation is back to target. The Boston and Atlanta Fed presidents said similar things earlier in the week.

We noted this growing tendency of investors to follow the economic data rather than the hawkish elements of Fed messaging, back in November.

The World Bank almost halved its 2023 global growth estimate to just 1.7% last week. It slashed its estimate for the advanced economies from 2.2% to 0.5%. Manufacturing Purchasing Managers’ Indices (PMIs) suggest a contraction in the U.S., Europe and Japan. And why worry about services inflation when the U.S. services PMI has just plummeted into contraction, from 56.5 to 49.6?

With a slowdown like this in the cards, many investors ask, won’t central banks be forced to cut rates again in the second half of 2023? Rates markets continue to price for that outcome.

Sticky Inflation

By contrast, we take the Fed and its peers at their word, because we continue to believe inflation will prove awkwardly sticky.

We think goods inflation has turned a corner. Energy and other commodities are difficult to call because they are subject to numerous factors—from the economic slowdown to the war in Ukraine, the reopening of China and the weather. Within services, we think shelter costs will ease slowly despite the uptick in December.

But we still anticipate sticky inflation in other services sectors, driven by higher wages in a tight, services-oriented labor market. U.S. jobless claims came in below consensus at a three-month low last week. At 3.5%, U.S. unemployment is near a 50-year low. Eurozone unemployment is also at a record low of 6.5%.

We see growing evidence of substantially increased wage settlements in Japan, Europe and the U.S.—topped by the 19% wage hike that ended a strike by New York nurses last week. Labor is fighting for a bigger share of the growth pie, and in our view this is a long-term and global story.

From our perspective, it’s not difficult to imagine a 2023 in which sticky, above-target services inflation is paired with a moderate slowdown that enables central banks to maintain higher rates for longer.

Buffer

These are some of the key themes in our latest quarterly Fixed Income Outlook.

We see U.S. and eurozone headline inflation declining to 3.0 – 3.5% by the end of 2023—much improved, but still above target. We see central bank policy rates and short-dated market rates reaching a peak that persists.

On the plus side, we think that means rates volatility is likely to be substantially lower than it was last year. For the first time in a long while, we see enough carry available in the market to compensate for duration risk and provide a buffer for total returns.

As we’ve seen in recent years, economic data and events can always surprise us—but for fixed income investors, we think 2023 offers more opportunity and much less risk than 2022.

For more details on our Fixed Income Team’s latest views, download the latest Fixed Income Outlook here.