Our liquidity team give their take on what the challenging market environment means for positioning in 2023.

Read this article to understand:

  • Why rate rises should feed through into increasing yields in liquidity strategies
  • Why risks to the outlook will require an active approach by investors
  • Three potential cash strategies for 2023

The outlook for cash investors in 2023 is broadly positive. Markets and professional forecasters expect central bank rate rises across developed markets, which will feed through to increasing yields in liquidity strategies. Our own House View favours a material overweight to cash:

“Cash, offering a decent yield and – assuming inflation abates – a store of value as well, is for the first time in many years a viable and essential tool to achieve target returns and manage risks for investors.”1

But there is always uncertainty. First, there is uncertainty as to the timing and peak level of central bank rates. Addressing a potentially highly variable rate environment will require prudent and, above all, active management of duration. Second, there is the potential impact of recessionary conditions on widely held issuers in liquidity portfolios.

While these issuers have adequate buffers to protect themselves from a deteriorating economic picture, we will continue to closely monitor evolving credit conditions.

Figure 1: Asset allocation

Asset allocation

Note: The weights in the table only apply to a model portfolio without mandate constraints.
Source: Aviva Investors, November 2022

Yields are rising

Rate hikes are positive for liquidity fund yields. Liquidity funds only hold short-dated securities. In a rising rate environment, as these securities mature, they are reinvested at the new, higher, prevailing rate. As a result, rate rises are passed on to investors quickly – typically much faster than bank deposits – and the risk of capital loss is low due to the high credit quality of issuers and diversification of the pools.

Market forward pricing and economic forecaster consensus point to rate rises across the board in 2023, which will feed through to increasing yields in liquidity funds. Cash investors can expect more yield – a welcome development after years of negligible yields and coming into a potentially recessionary environment, when every pound, dollar or euro available will count.

Figure 2: Market forecasts

  EUR GBP USD
Current rate 2.0% 3.50% 4.50%
Rate peak – level 3.340% 4.422% 4.919%
Rate peak – timing July August June
Next rate movement +49bp +45bp +27bp

Note: EUR = deposit facility.
Source: Bloomberg World Interest Rate Probability model – OIS. Data of January 13, 2023

Market pricing currently suggests front-loaded central bank rate hikes in the first half of 2023.

Market pricing currently suggests front-loaded central bank rate hikes in the first half of 2023

Economic forecasters broadly concur, with rates rising in the first half before plateauing or even beginning to decline later in the year. Forecast variance is, however, wide. Taking the UK base rate as an example, the median forecast for the year-end rate is 4.25 per cent, with a low estimate of three per cent and a high of six per cent.

With inflation expected to fall, these cash returns will be close to, and eventually above, the loss of value in each currency: in such an event, positive real returns will have, at long last, reappeared.

Figure 3: Economist forecasts

  Euro zone UK US
Q1 2023 2.50% 4.25% 5.00%
Q2 2023 2.75% 4.25% 5.00%
Q3 2023 2.50% 4.25% 5.00%
Q4 2023 2.75% 4.25% 4.75%

Source: Bloomberg Economic forecast contributor composite. Data as of January 16, 2023

A UK base rate of 4.25 to 4.5 per cent would be consistent with recent history: over the last 25 years, the average prevailing base rate was around 2.65 per cent, with a standard deviation of 2.44 per cent. A base rate of 4.25 to 4.5 per cent would be well within the normal historical range (the one standard deviation daily range is approximately 0.2 to 5.1 per cent). 

Clearly, this “modern” distribution is skewed by the prolonged recent period of near-zero rates. Looking at a longer period – going back to the mid-1970s, an era of stagflation (weak or negative growth alongside high inflation) – would yield an average rate of around 6.3 per cent with a normal daily range of approximately 1.6 to 11.1 per cent.2

Figure 4: UK base rate

Source: Bank of England. Data as of January 13, 2023

The market, economists and history suggest the direction of travel is clear, and the expected peak is reasonably consistent.

Beware the forecast error

Much as markets and economists are broadly aligned, it is worthwhile pausing for a moment to reflect on error.

Much as markets and economists are broadly aligned, it is worthwhile pausing for a moment to reflect on error

Markets and economists were not expecting the Russian invasion of Ukraine in February 2022, let alone the UK political and market turmoil last September.

To put this into context, around one year ago, investors were considering the following forecasts:

  • Market forecast for the UK base rate post December 2022 rate-setting meeting: 1.244 per cent3
  • Median professional forecaster projection for the UK base rate as of end 2022: 0.5 per cent4

The reality? The Bank of England increased the base rate to 3.5 per cent on 15 December 2022. Professional forecasts and guidance and predictions of other central banks about almost every economy were just as inaccurate. Today, there is greater appreciation of the range of potential scenarios and the inherent uncertainty in outcomes.

Positioning our liquidity strategies

Figure 5: Liquidity position

Credit

• Favour higher quality allocations

• Monitoring for impact of potential recession

Rates

• Keeping duration low to benefit from rate rises

• Inflation as key indicator for potential policy paths

Spread

• Favour floating over fixed rate products

• Appetite tempered by valuations and potential mark-to-market effects

Liquidity

• Maintaining stable liquidity levels

• Flow outlook stable, but maintaining buffers against potential volatility

Source: Aviva Investors, January 2023

1. Credit fundamentals sound

Financials – the core of the investible universe for liquidity strategies – are fundamentally sound. Prudential policies implemented during the pandemic mean bank balance sheets are currently robust. Furthermore, rising rates typically feed through to bank profitability (through net-interest margin), providing an additional buffer against more challenging conditions.

The risk of recession is high, and the effects would be felt by banks

Nonetheless, the risk of recession is high, and the effects would be felt by banks. We are focused on the labour market: if unemployment increases, this would lead to increases in non-performing loans and increased provisioning requirements by banks. With labour markets in all major economies currently remaining tight, however, we view this risk as manageable.

We see the property market as a secondary, albeit closely related, topic to unemployment. House prices are falling in many countries but remain above pre-COVID levels. Additionally, mortgages tend to be skewed to higher-income households, which are insulated somewhat from the effect of inflation on the cost of living. Furthermore, modelled scenarios for house price declines in prudential stress tests have not – as yet – been breached, indicating capital is prudently positioned.

Credit rating agencies currently have broadly stable rating outlooks for financials. Notwithstanding idiosyncratic credit developments, this indicates that the distance to downgrade (let alone default) is adequate, particularly among the higher-quality names in which our liquidity strategies invest. In this context, valuations, as opposed to credit fundamentals, will be key to performance in 2023.

Accordingly, we favour higher credit quality positioning, especially in longer-dated (floating-rate) exposures.

2. Rates and spreads primary focus

Inflation is the key indicator for 2023 across currencies. Risks are two-sided: if inflation is more entrenched, then despite economic weakness, central banks will have to remain restrictive, or perhaps even fine-tune with additional hikes, after a pause.

The rate cuts implied by inverted yield curves across markets could get priced out or pushed further into the future. That would punish bondholders with capital losses, in addition to negative carry. The upside scenario for bonds is that inflation either proves transitory after all or that a hard landing occurs, necessitating lower yields to cushion economic distress.

As long as both scenarios remain realistic, yield curves will most likely remain inverted beyond near-term maturities until central banks are expected to reverse hikes imminently.

We expect the inflation picture to result in higher rates for longer, but exactly how high they go is debatable

From a liquidity investment perspective, we expect the inflation picture to result in higher rates for longer, but exactly how high they go is debatable. There are material risks to the outlook and hence potential for mark-to-market volatility affecting longer-dated securities in particular.

The picture varies across currencies. In US dollars, some longer-dated securities offer attractive yields, particularly if US rates begin to fall later in the year. However, we are conscious of upcoming risk events, such as the debt ceiling negotiations, which could trigger volatility. In euros, the repayment of targeted long-term refinancing operations is underway. While we expect draining of excess liquidity to be positive for euro money markets eventually, there is the potential for volatility, particularly as re-payment windows approach.

Accordingly, we are currently keeping our positioning short; where we do add longer-dated exposure, we will be highly selective. If we see signs inflation is coming under control, in a sustainable manner, we may adjust our positioning to increase duration exposure. However, any such change would be tempered by the broader picture – we are acutely conscious of how geopolitics and the rising cost of living could affect market-specific political developments. All these possibilities signal potential volatility and warrant a prudent approach.

3. Stable liquidity provides protection

We expect liquidity to remain stable in liquidity strategies in 2023, with buffers above regulatory minima. For example, sterling liquidity portfolios averaged around 42 per cent weekly liquid assets at end-December 2022, well above the 30 per cent required under applicable regulation.5

Sterling liquidity funds have maintained high liquidity since the September 2022 market shock, despite broadly experiencing inflows since then, implying liquidity may be higher than currently warranted. Liquidity is similarly high in euro and US dollar portfolios.

The applicable regulation for liquidity funds is currently under review. If there are regulatory developments in 2023, these could lead to funds needing to increase minimum liquidity levels. However, taking into consideration the timelines involved in regulatory decision making and the potential for extended implementation periods for any changes, it’s unlikely there will be structural changes to liquidity requirements in 2023.

For more information on potential reforms to liquidity funds, see our article European money market fund reform: Preparing for change.6

Three cash investment strategies for 2023

In this context, we see three main opportunities for cash investors:

  1. Allocating to liquidity funds:  Liquidity funds will re-set quickly to the prevailing interest rate environment. This means funds should be able to quickly pass on rate rises to end investors. For example, sterling liquidity funds were yielding 3.45 per cent gross on average on 13 January 2023, 31 business days after the most recent rate hike of 50 basis points, demonstrating a rapid transmission of policy developments to investors.7
  2. Allocating to short-term bond funds: As we discussed recently in Enhanced cash in short-duration fixed income, we see significant opportunities for investors in short-duration credit – i.e. securities just outside the typical investible universe for liquidity funds. Opportunities look particularly strong across asset classes – notably asset-backed securities – bringing the potential of both stable returns above cash and diversification.
  3. Locking in: Yield curves across currencies are steep at the short end, while falling in the mid- to long-term. This implies investors view near-term prospects (rate rises) as more positive than longer-term prospects (economic issues). Given the expectation of rates plateauing – or even beginning to decline – in late 2023, investors may generate attractive returns from locking-in relatively short-dated baskets of securities, providing potential diversification, high credit quality and, most importantly, attractive yields available now.

Figure 6: SONIA curve

Source: Bloomberg. Data as of 13 January 2023

Key takeaways

Transitions are often associated with volatility. 2022 was certainly a year of transition – from a period of low and relatively unchanging rates to a period of changing, and potentially more variable rates, going forward.

Transitions are often associated with volatility. 2022 was certainly a year of transition

The year was extraordinarily volatile. In 2023, investors could benefit from allocating to cash, both to dampen potential broader portfolio volatility and capitalise on the attractive returns available now, along with the prospect of rising rates feeding through to improving yields.

UK central bank rate: A historical perspective

The Bank of England raised rates eight times in 2022, with a total increase of 325 basis points.  The biggest single hike was 75 basis points in November. But how does this compare to history?

Eight rate changes in one year are relatively unusual – at the 85th percentile of the distribution going back to 1822. Even so, eight rate changes pale into insignificance when compared with the 36 rate changes (34 cuts and two hikes) in 1982. Interestingly, the mid-1970s to mid-1980s saw a cluster of sequential years with numerous rate adjustments. Around half of all observations are two or fewer rate changes in any given year.

The 75 basis point hike in November was a historical curiosity: the Bank had never changed the rate by such an amount before. The most common rate movements are (in order) -50, 50, 100 and -100 basis points, showing a wide variation.

The distribution is also wide: the largest-ever rate movements were both in 1914 (at the outbreak of the World War 1) when the Bank increased rates by 400 basis points at end-July (as tensions between Austria-Hungary and Serbia rose following the assassination of Archduke Franz Ferdinand), only to decrease rates by 400 basis points six days later (when war was declared), followed by a further cut of 100 basis points on August 8, bring the prevailing rate down to five per cent.

The total rate change last year of 325 basis points is also on the outer range of the historical distribution. In any given year, the most common net outcome is no change. The most substantial net total rate hike ever was in 1978 – 550 basis points – while the most substantial net total cut was the preceding year – 725 basis points. Again, a wide variation.

What to make of this? Simply put, it is a reminder to investors we have experienced a recent period of unusually low interest rates and lack of interest rate movements – rates did not change at all between March 2009 and August 2016 (with the rate hikes that followed a damp squib in terms of rate movements).

The last time rates did not move for such an extended period was in World War II (the base rate was two per cent between October 26, 1939 and November 7, 1951, before sequential hikes to a peak of seven per cent in September 1957). That is the key point – wars, banking crises and commodity shocks seem to drive the most frenetic periods of Bank of England rate-setting activity.

It may, therefore, be advisable to adjust our thinking and be prepared for a more variable rate environment. Active management will be key.

Source: Bank of England, Aviva Investors analysis, January 2023

References

  1. “House View 2023 Outlook”, Aviva Investors, December 2022
  2. The average rate since the Bank of England’s records begin (in 1694) is around six per cent, expressed in terms of rate changes (i.e., the average of the bank rate each time the rate changed)
  3. WIRP as of January 10, 2022
  4. HM Treasury, “Forecasts for the UK Economy: December 2021”, GOV.UK, December 15, 2021
  5. Refers to low volatility net asset value money market funds, data iMoneyNet as of end-December 2022
  6. Alastair Sewell, “European money market fund reform: Preparing for change”, Aviva Investors, September 15, 2022
  7. iMoneyNet, 1-day simple yield, annualised, January 9, 2023

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