Markets swayed by inflation and growth prospects

Changes in the anticipated monetary stance and in the economic outlook continued to shape financial markets in the review period.¹ The interplay of shifting inflation dynamics and deteriorating growth gave rise to two phases. In the first, from mid-September to mid-October, inflation readings came in stronger than anticipated, pushing up expectations of policy rates in the near future. In the second, through November, lower than expected inflation and weakening economic activity led markets to reassess downward the extent of policy tightening ultimately needed to contain inflation. These developments kept asset price volatility elevated in the context of poor liquidity conditions across market segments, contributing to swings in global financial conditions.

Markets tracked the synchronised rise in expected policy rates through mid-October. As a result of the inflation surprise in September, investors' expectations of policy rates started rising rapidly in core markets. This pushed yields upwards amid low liquidity, supporting the US dollar and weighing on risky assets.

In late October and especially in November, market dynamics reflected investors' perception of a decline in terminal rates. As the US yield curve inverted further, the US dollar fell vis-à-vis most currencies from multi-decade highs, alleviating pressures in funding markets. Equities recouped losses, thanks in part to easing energy concerns in Europe, while poor earnings weighed on the technology sector. Corporate bond spreads compressed slightly but remained wide in Europe. Issuance continued to be limited in the investment grade (IG) segment and was minimal for high-yield (HY) bonds.

Commodity prices eased in most markets, despite clouds on the horizon. The decline was especially sharp for natural gas in Europe, but crude oil also fell markedly. However, lingering supply disruptions showed up in the markups for refined products, and long-term energy concerns persisted.

Assets in emerging market economies (EMEs) largely tracked those in AEs. Sovereign yields rose at a quick clip early in the review period and then trended down as the dollar weakened and financial conditions eased. China was an exception in October, as persistent stresses in the real estate sector and weakness in consumer demand weighed heavily on equities, including those of trading partners, and drove outflows from bonds, especially those issued offshore. Policy actions supported Chinese assets in November.

The monetary policy outlook shaped core bond markets

Shifting market expectations for the monetary policy outlook set the tone for yield curves over the review period. In September, expected policy rates for 2023 rose across all major advanced economies (AEs) after surprisingly high inflation readings. Subsequently, the evolution of these rates diverged somewhat, but they largely stabilised in November after US inflation surprised on the downside (Graph 1.A). In parallel, short-term sovereign yields rose steadily and then plateaued in the United States and Germany. As long-term sovereign yields dropped, yield curve slopes inverted further in the United States and turned negative in Germany and other AEs (Graph 1.B). Together with nominal yields, US forward interest rates rose on net but fell in November, as market participants reassessed downward the terminal policy rate (Graph 1.C).

The interest rate outlook was uncertain, and bond market liquidity deteriorated in most AEs. Despite some swings, option-implied volatility for US rates remained very elevated throughout the review period (Graph 2.A). As rates climbed rapidly and volatility increased, bond markets turned progressively less liquid. For instance, a common liquidity measure based on bond prices² worsened markedly and reached its lowest level since the Great Financial Crisis (GFC) for a group of AEs (Graph 2.B). In the United States, liquidity conditions had started deteriorating during the summer and were stable over the review period, remaining noticeably worse than during the March 2020 episode of Treasury market dysfunction. Across AEs, these conditions improved somewhat after mid-October as market expectations of rate volatility fell. That said, liquidity appeared fragile in some market segments, such as those supporting US mortgage credit (Box A).

The market for long-dated UK government bonds came under severe stress in late September. The initial increase in yields followed the Bank of England's monetary policy decision and the announcement of a fiscal plan that included tax cuts and energy subsidies. Subsequently, yields rose further on the back of rapid sales by leveraged investment vehicles that pension funds employ (Box B; Graph 3.A). Illiquidity compounded these self-reinforcing dynamics. Eventually, following targeted and temporary central bank bond purchases aimed at restoring market functioning, yields retraced most of their increase.

In Japan, investors continued to wager that the yield curve control policy would eventually be relaxed. This policy caps the yield on 10-year Japanese government bonds at 25 basis points. However, corresponding rates in derivatives markets, which the Bank of Japan does not target directly, rose rapidly to exceed cash yields by a wide margin (Graph 3.B). In parallel, the yen depreciated, prompting foreign exchange (FX) interventions.

Similar to the evolution of long-term core bond yields, sovereign bond spreads in the euro area widened through October but compressed thereafter. The narrowing was especially pronounced for Greek and Italian bonds. That said, the spreads on these bonds remained much wider than for other euro area members and, in the case of Italy, were markedly higher than early in the year (Graph 3.C).

After extended gains that led to multi-decade highs, the US dollar paused and then weakened. The dollar's nominal effective exchange rate fell by about 2% following the lower than expected CPI release in November, as market participants reassessed the outlook for interest rate differentials (Graph 4.A). In particular, the US dollar weakened against the euro and the yen over the review period as a whole. Against the backdrop of relatively poor liquidity in major FX markets, option-implied FX volatility climbed further to reach post-Covid-19 highs in most cases. More broadly, signs of significant strains in dollar funding markets emerged as year-end approached but then eased when the dollar weakened (Graph 4.B).

Risky assets fluctuated as uncertainty rose

Equity prices were attuned to the monetary policy outlook and saw pronounced swings. In October and especially in November, stocks were bolstered by investors' downward reassessment of ultimate policy tightening, even as expectations of near-term policy rates changed little and corporate earnings proved weak (Graphs 5 A and 5.B). The closing of short positions probably contributed to spikes in stock prices in early October and mid-November. Chinese equities were under pressure for most of the review period due to economic weakness but rose in November on expectations of less stringent pandemic management.

Corporate bond markets showed some signs of strain. Yield spreads over sovereign bonds widened in September and October, ending the review period at and above historical norms in the United States and Europe, respectively, after a tightening in November (Graph 6.A). Average spreads in Q4 2022 appeared broadly in line with the economic backdrop (Graph 6.B). In the background, perceived default risk picked up and was somewhat elevated for IG firms (Graph 6.C). In this context, issuance dried up in the HY segment, until a tentative reprise in November, and declined sharply for IG firms, approaching its lowest levels since the GFC (Graph 7.A).

Leveraged loans, which tend to be more sensitive to rising interest rates due to their floating coupons, were also under some pressure. Notably, syndicate underwriters engaged in large sales. While significant discounts attracted purchases by collateralised loan obligations (CLOs), the demand from traditional buyers for these securitisations – notably for their senior tranches – remained limited.

Financial conditions tightened somewhat in AEs. The initial change was particularly marked in the United States, mostly driven by rising long-term rates and declining equities (Graph 7.B). In October, US financial conditions became more restrictive than the long-term average for the first time since April 2020. However, they eased as risky assets gained ground in November, ending the period under review at a similar level as at the start. Other AEs also saw a tightening, but it was more contained than in the United States because of a more limited increase in long-term rates.

In commodity markets, futures prices signalled lingering concerns about long-term natural gas supply in Europe. Spot natural gas prices fell sharply, especially in Europe (Graph 8.A). The drop was partly due to unusually warm weather and ample storage before winter. However, investors fretted about long-term imbalances, leaving futures prices two years ahead unchanged over the review period, even as prices three months ahead fell sharply (Graph 8.B). Some energy markets still experienced supply issues. For instance, technical constraints that curbed shipments from a US pricing hub for natural gas resulted in briefly negative prices there (Graph 8.C, red line). In addition, limited refining capacity kept diesel prices relatively high compared with other fuels, even as oil prices fell (Graph 8.C, blue line).

EMEs were relatively resilient, but not without fragilities

Dynamics in AEs influenced financial conditions in EMEs. In line with AE risky assets and long-term core bond yields, conditions tightened significantly early in the review period before easing sharply in November (Graph 9.A).

EMEs' local currency sovereign yields largely tracked those in AEs. In September, they rose especially quickly in Asia (excluding China) and in EMEA,³ but the increase was notable in Latin America as well (Graph 9.B). The subsequent reversal was smaller in Asia. Local currency spreads over US Treasuries held up, suggesting that the bulk of yield adjustments owed to higher Treasury yields.

Corporate bond spreads picked up in some EMEs, especially in emerging Asia excluding China (Graph 9.C). At the end of the review period, they remained somewhat wider than historical standards. Notably, in Korea short-term corporate funding costs increased rapidly as credit quality concerns emerged. Corporate spreads widened significantly, as companies struggled to refinance maturing debts. Authorities acted as buyers of last resort to restore orderly market functioning. That said, financial conditions kept tightening in Korea due to rising short-term rates (Graph 9.A).

Most EME currencies continued to depreciate against the US dollar through October, before strengthening in November (Graph 9.D). The key determinants of exchange rates continued to be cross-country differences in inflation and monetary policy outlooks as well as exposure to external and terms-of-trade shocks.

In China, the growth outlook was clouded through October by weakness in the real estate sector and by persistent Covid restrictions. The perception that real estate developers would need to further restrict activity to meet balance sheet prudential ratios cast a shadow on the near-term outlook. As a result, the sector's stocks contributed to the decline of a broad equity index up to end-October (Graph 10.A). Covid-related restrictions put pressure on consumption, adding to headwinds from real estate. Overall, slowing activity in China weighed on the equity returns of its trading partners, particularly those most reliant on Chinese exports (Graph 10.B).

New policies aimed at easing credit flows offered some respite to risky assets in early November. Chinese equities rose sharply, led by the real estate sector. In parallel, the renminbi appreciated against the US dollar, while the credit default swap spread on Chinese sovereign bonds fell after doubling midway through the review period (Graph 11.A). While outflows from Chinese bonds quickened somewhat, they remained below early 2022 levels (Graph 11.B)

Technical annex

HY = high-yield; IG = investment grade; JGB = Japanese government bond; OIS = overnight indexed swap; YCC = yield curve control policy.

Graph 1.A: For US, federal funds rates implied by futures maturing in December 2023. For EA, rates implied by ESTR futures maturing in December 2023.

Graph 1.B: "Other AEs" is based on data for AU, CA, DK, GB, JP, NZ and SE.

Graph 1.C: US instantaneous forward rate two years hence, adjusted for risk premium. Based on the model of D Kim and J Wright, "An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates", FEDS Working Papers, no 2005-33, 2005.

Graph 2.B: Bloomberg government securities liquidity indices, defined as the average yield error for government securities with more than one year of remaining maturity. The indices are displayed on an inverted scale.

Graph 4.A: "Other AEs" is based on US dollar exchange rates for AUD, CAD, CHF, GBP, NZD, NOK and SEK.

Graph 5.B: Expected earnings per share growth between end-2021 and estimated end-2023. As to big tech returns, this is calculated as the simple average of Apple, Microsoft, Amazon, Alphabet and Meta cumulative stock returns.

Graph 7.A: For Q4 2022, issuance data up to 25 November 2022, extrapolated to full quarter.

Graph 7.B: Goldman Sachs Financial Conditions Index (FCI): a weighted average of country-specific risk-free interest rates, exchange rates, equity valuations and credit spreads, with weights that correspond to the estimated impact of each variable on GDP. A value of 100 indicates average conditions. A higher (lower) value indicates tighter (looser) conditions.

Graph 9.A: See entry for Graph 7.B.

Graph 9.B: Simple averages of JPMorgan Chase GBI Global sub-indices, traded yields.

Graph 9.C: Simple averages of JPMorgan Chase CEMBI sub-indices, stripped spreads.

Graph 9.D: "Other EMEs" is based on US dollar exchange rates for BRL, CLP, COP, CZK, HKD, IDR, ILS, INR, KRW, MYR, PHP, PLN, RUB, SAR, SGD, SOL, THB, TRL, TWD and ZAR.

Graph 11.B: Monthly bond flows: flows to local currency bond funds, scaled by previous month's assets. The 10-year rate differential is the monthly average of the difference between the 10-year local currency sovereign bond yield and the 10-year US Treasury yield.

¹ The period under review extends from 13 September 2022 to 25 November 2022.

² Based on deviations of bond prices from a smooth theoretical yield curve.

³ Europe, the Middle East and Africa.