Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Summary: A quiet session yesterday with US equity markets closed saw the mood around the rest of the world brightening somewhat, as the crypto market stabilized again after a traumatic weekend, and US futures are up sharply again overnight after testing cycle lows late last week. The US Fed’s Bullard continues to beat the hawkish drum for the Fed, arguing that US inflation expectations risk becoming unmoored if the Fed doesn’t follow through with more tightening.
Nasdaq 100 and S&P 500 are rebounding with the S&P 500 futures trading around the 3,730 level this morning in Europe with the 3,744 level being the first resistance level to watch on the upside. Commodities are coming down due to increased risks of recession and China’s economy still struggling to shift gear easing pressures on inflation and companies’ margins. The VIX forward curve is mostly flat with the VIX sitting around the 31 level and the US 10-year yield rebounding a bit together with equities to 3.28%. Overall, our thinking is that the downward pressure on equities has slowed for now as recession fears will keep a lid on the factors that have been negative for equities, so a rebound to the 3,800 level in S&P 500 futures is potentially where the market goes next.
The two indices were up 1.6% and 0.2% respectively. Digital health service platform stocks surged, with Alibaba Health (00241) up 11%, Ping An Healthcare (01833) up 3% and JD Health (06618) up 4%. In A-shares, steel manufacturers rose. China is studying plans to help downstream manufacturers on rising input costs and to narrow the profitability gap between upstream and downstream industries. The Chinese authorities are also going to roll out relief measures helping coal-fired power plants.
Yields rebounded in Europe yesterday and never really consolidated much, relative to their US treasury counterparts. If the global yield picture continues to rise again – and especially if the longer end of the US yield curve presses higher to new cycle highs of 3.50% and beyond, USDJPY and other JPY crosses are likely set for a renewed surge higher as the Bank of Japan has lost control of its balance sheet and the Japanese Government Bond (JGB) market is dysfunctional as it defends the 0.25% yield cap on 10-year JGB’s. The BoJ bought $81 billion of JGB’s to defend the cap last week, a record amount.
The crypto markets are slowly making a comeback after the traumatic weekend, and Bitcoin is trading above $21k this morning. According to a newly published report by CoinShares tracking digital asset funds, the short-Bitcoin investment products saw a record-high outflow last week, hinting that negative investor sentiment has peaked for now.
Gold (XAUUSD) and other precious metals are stuck in a range as the tug of war between inflation and recession concerns pans out. While gold remains an inflation hedge, the surge in US treasury yields will continue to cap gains especially if we get closer to pricing in another 75bps rate hike from the Fed in July. Only after recession concerns take over inflation and US yields top out do we see a case for sustained gains in Gold, but we maintain our bullish view on gold and expect it to print a new high in the second half of this year.
ECB’s president Christine Lagarde confirmed yesterday to the European Parliament the central bank’s willingness to design a new tool to counter bond market panic. Expect this new tool to have at least three main features : 1) it should be country-specific ; 2) it needs to be applied only when the debt sustainability of the countries in question is validated by a process that ensures political legitimacy (but it should not be conditional on European Stability Mechanism approval, for instance) and 3) it needs to be coordinated with interest rate decisions. Lagarde mentioned that risks to financial stability have considerably increased since the beginning of the year too. She fears we may see a correction of real estate prices in several countries. This is something to monitor closely. The Germany-Italy yield spread is at the low end of the range since early May, just under 200 basis points as of yesterday’s closing prices.
... with traders digesting an improved outlook for global food supplies. The weakness seen so far this month has been led by wheat and edible oil, the two categories which led the March surge after Russia’s attack on Ukraine raised concerns about supplies from a major exporter of food commodities. While those worries have not gone away, the outlook for wheat production in Russia and the U.S. have picked up, this to the point CBOT wheat (ZWN2) has broken support at $10.37 with the next level of support around $9.6. Palm oil futures in Malaysia has slumped by 20% this month on burgeoning exports from Indonesia.
The Fed Chair will be in the hot seat this week in the required semi-annual testimony before Congress, where politicians on the committees often take a chance to grandstand on their own political positions and observations, but after several months of decades-high inflation and record gasoline prices, will this week’s testimony show that the political pressure on the Fed is mounting? The market will also watch for any new comments from the Fed Chair, although we are just a few days removed from the FOMC press conference.
The US housing market is decelerating, and quickly. Prices are up almost 40 % since the outbreak, mostly reflecting stimulus-fueled demand during a period of record low rates in 2020-21 that now feels ancient history. With high inflation across the board pushing consumer confidence downward and mortgage rates surging following the U.S. Federal Reserve’s tightening cycle, the risks of hard landing are rising. Over the past few weeks, several large real estate firms such as Redfin Corporation have warned against the risk of slowdown. Expect a drop in May’s existing home sales and perhaps a new plunge in the number of new home sales after disappointing data in April (minus 16.6 %). The U.S. housing market is certainly the most vulnerable segment of the U.S. economy at the moment. It will be key to monitor the upcoming data in order to assess whether there is a material risk of recession.
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