Asia credit outlook: where next for the Fed?

We believe the conditions are right to make Asia/emerging market (EM) credit look more attractive to investors, against a macro backdrop of global disinflation, developed market (DM) rate cuts and global growth of ~2.5%. There are encouraging signs that a number of Asian markets are primed for a ‘near-perfect’ credit environment.

In the first of a three-part series on the outlook for Asia fixed income in 2024, we focus on the global economic backdrop and outline our scenarios for the US Federal Reserve (Fed) rate path. 

 

Need to know We believe Fed’s rate reduction cycle will be gradual, and around 200 basis points over six to eight quarters One factor that could keep US Treasury yields marginally higher all else being equal, is additional US Treasury issuance owing to higher US fiscal deficit In our view, it looks as though the Fed will cut rates more than Asian central banks in the coming year

 

US mid-cycle slowdown

DM inflation has made a significant round-trip, rising from under 2% to over 9% and now back to around 3%. Just as the Federal Reserve was surprised with surging inflation, it has also been surprised how fast it has dropped over 2023 owing to goods deflation and services disinflation. It has now increased its projections for rate cuts in 2024 from two to three, and markets have quickly repositioned towards easier liquidity conditions globally.

However, clouding the certainty of Fed rate cuts going forward is that it is not yet clear when cuts will start, what the pace of cuts will be, the steady-state of Fed rates over the medium term, and the extent of the slowdown of the US economy. Markets then have to contend with the extent to which China and Europe will experience a slowdown over 2024-2025.

Nevertheless, we believe the range of uncertainties are much less now than over the past three years. We expect the US to only experience a mid-cycle slowdown, as it continues to grow over the coming years. The lack of slack in labour markets in developed markets will keep unemployment moderately low, support the consumer liquidity and their balance sheets, and only necessitate a gradual DM rate cutting or normalisation path. We expect the Fed to normalise rates from 5.5% towards 3.5%, i.e., 200 basis points (bps) from the time of the first rate cut into 2026. Global central banks will follow, including the ones in Asia as well as EMs. This will hence be a relatively synchronised global rate normalisation cycle over the coming two years, with exception of China and Japan.

 

US Federal Reserve rate path

In the US, the core Personal Consumption Expenditures (PCE) measure of inflation has improved with the annual measure down to 3.2%. Looking at the last 6 months and annualising it, inflation is now at 1.9% which is below the Federal Reserve’s (Fed’s) 2% target for the first time since 2021. This is a significant development, although we respect that there can be some volatility around these inflation prints. The drivers of lower inflation are essentially goods deflation and better services disinflation.

Despite expectations that inflation will slide below 3% in H1 2024, we alongside consensus recognise that US labour markets remain strong and the slack in the economy is significantly less than in previous cycles. The consumer asset side of its balance sheet has expanded healthily over the last ten years. Couple this with new structural shifts of US manufacturing shifts, reinvestment into new climate-based solutions and greater fiscal funding, we believe there is a good case to be made that:

• Fed neutral rate has risen from 2.25% towards 2.5% to 2.75% over the coming years
• There is a structural demand for term premia in the longer end of the US Treasury curve
• There is no need for the Fed to cut rates drastically by the tune of 300 basis points (bps) to abruptly end the historical tightening cycle

We believe Fed’s rate reduction cycle will be gradual, and around 200 bps over six to eight quarters. Rate reduction past 2025 will be very much determined by the US presidential cycle, and the fiscal and growth policies dictated thereafter.

Of the four potential scenarios outlined in figure 1, we believe that markets are most closely aligned with number one. In our view, with US Treasury 10-year yields at ~4%, this represents an attractive long-term level, since we consider ~3.75% fair value in H1 2024, with a longer term upper bound of 4%. Fair value for the end of 2024 looks to be around 3.5%.

 

FIG. 1 FED LONG-TERM NEUTRAL RATE SCENARIO ANALYSIS

Sources: US fed rate scenarios. Source: Bloomberg, LOIM. As at 2 January 2023. For illustrative purposes only.

 

FIG. 2 POTENTIAL FED RATE PATHS – GRADUAL (AND NOT FAST) NORMALISATION

Source: LT fed rate path. Source: Bloomberg, Federal Reserve, Lombard Odier calculations. As at 2 January 2024. For illustrative purposes only.

 

One factor that could keep US Treasury yields marginally higher all else being equal, is additional US Treasury issuance owing to higher US fiscal deficit. However, US fiscal deficit is not intended to rise much year-on-year in 2024, and most of the additional issuance that will likely transpire will be in the zero- to two-year US Treasury bond issuance bucket and about over USD 300bn more in the five to ten-year bucket (see figure 4). We believe this additional issuance can comfortably be absorbed by the market, unless there is temporary indigestion of additional US Treasury issuance that we witnessed during Q3 2023 versus 2022 trends.

 

FIG. 3 US FISCAL DEFICIT FORECAST

Sources: US Fiscal Deficit Forecast. Goldman Sachs Research. As at 13 December 2023. For illustrative purposes only.

 

FIG. 4 NET ISSUANCE OF US NOTES

Source: Net Issuance of US Notes. Source: Barclays Research. As at 4 December 2023. For illustrative purposes only.

 

Asian central banks to start easing in 2024

In our view, it looks as though the Fed will cut rates more than Asian central banks in the coming year.  The Asian economies have managed inflation relatively better than the US, which means that fewer interest rate hikes have been required over the last two years. Therefore, the Fed will require more rate cuts relative to its Asian counterparts in this cycle.

What this means for investors is that the increasing differential in policy rates from H2 2024 will make USD funding more attractive versus Asian local currency.

A weaker USD will lead to lower forex (FX) hedging cost, and increased demand for USD spread products from domestic Asian investors.

 

FIG. 5 ASIAN CENTRAL BANK POLICY RATES FORECAST

Source: CEIC data, Bloomberg, Goldman Sachs, Lombard Odier calculations. As at 12 December 2023. (salman).

 

The next in this series will focus on the potential advantages afforded to Asia and EMs from global monetary easing.

 

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