Head of Fixed Income Strategy
Summary: This week, investors will focus on the US CPI data as a surprise on the upside might advance rate hikes expectations and further flatten the US yield curve. In the forward market, the 2s10s spread is already inverted one year out, pointing that tightening in a slowing economy might bring a recession sooner than expected, but not this year. Credit spreads continue to widen gradually in the corporate space, with junk bonds being still more resilient than high-grade bonds. However, as volatility in bond markets remains elevated and the Federal Reserve begins hiking interest rates, chances for a tantrum increase. Finally, for the ECB meeting this week, we believe it'll show that policy normalization is on track, although we don't know when it'll start. Therefore, yields in the euro area are likely to stay compressed a little bit longer before resuming their rise. Yet, we still believe that negative bund yields will soon be a memory of the past.
The bond market signals troubles ahead. Last week long-term yields dropped amid safe-haven demand. In contrast, the front part of the yield curve remained elevated as the market understood that the Federal Reserve would not be able to shy away from interest rate hikes.
In the forward market, the 2s10s spread is already inverted one year out, pointing that tightening in a slowing economy might bring a recession sooner than the market expects.
In the meantime, the FRA/OIS spread continues to widen to the highest level since the Covid pandemic signaling that counterparty risk might become a problem.
The bond market might continue to be turbulent this week as investors are expecting the US CPI figures to come at 7.9%. Any surprises on the upside might revive speculations that Fed may still consider a 50bps rate hike next week, accelerating the rise of the front part of the yield curve. Yet, we cannot take anything for granted as treasuries remain highly sensitive to headlines concerning the war in Ukraine. We believe that the yield curve will continue to bear-flatten in the mid-term as the market adjusts between inflation and growth.
The US Treasury will start to sell bonds tomorrow with a 3-year auction. It will be followed by 10-year and 30-year bond sales on Wednesday and Thursday. While we expect demand for the long part of the yield curve to remain sustained amid investors' flight to safety, it will be interesting to see how market participants are going to position for tomorrow's 3- year note sale. In January, the 3-year notes were priced with a high yield of 1.592%, the highest since December 2019, attracting high demand. Currently, 3-year yields are slightly higher at 1.62%. Yet, investors might decide to skip this one in light of an expected hawkish FOMC meeting next week.
We see troubles mounting within the corporate bond space. Despite the primary high-yield bond space resumed its activity last week after two weeks of complete silence, we are afraid that the sustained volatility in Treasuries will soon start to pose a threat to weaker companies looking to issue debt. The MOVE index rose to the highest level since the 2020 Covid pandemic, and it is already above 2013 taper tantrum levels. In the meantime, credit spreads gradually widen, showing some resilience to the elevated volatility. However, things might change as investors realize that the macroeconomic backdrop is quickly becoming hostile for weaker corporates amid high inflation and a slowdown in growth.
Yet, demand for junk bonds remains supported as investors look to build a buffer against inflation and rising interest rates. Indeed, high-grade corporates are much more sensitive to rising rates. Only the expectation of an aggressive tightening cycle led them to drop by -5.5% since the beginning of the year, while junk fell by -4% only.
There is no space for directional strategies within the context described in the previous paragraph. It is necessary to manage duration with flexibility picking credit selectively and being prepared to hold on to these securities until maturity to avoid capital losses.
Investors will be focusing on the ECB meeting on Thursday in the euro area. Since the beginning of the war in Ukraine, markets have pared back on interest rate hikes expectations in the euro area. That caused a considerable rally in European sovereigns, which saw 10-year German Bund yields dropping below 0%, and sovereign spreads in the euro area tightening.
The problem we see is that it is very likely that monetary policy normalization in the euro area has not been suspended but merely delayed. Indeed, sooner or later, the ECB will need to intervene to curb inflationary pressures. That means that although yields might remain compressed for a few more quarters, sooner or later, the ECB must terminate its QE program and begin to hike interest rates. Consequently, negative Bund yields will be a thing of the past.
The market will be focusing on the ECB economic forecasts, especially on inflation figures for 2023 and 2024. In December, the central bank expected inflation to drop below 2% by next year. If the forecasts now rise to 2%, it might signal that the central bank will need to be more aggressive throughout the year.
It's important to note that the recent tightening of spreads across the euro area cannot be attributed to the flight to safety caused by the war in Ukraine. The fast tightening of spreads has been caused by the market paring back on interest rate hikes expectations. Therefore, any suspicion that the ECB will be aggressive could threaten the periphery and provoke sovereign spread such as the BTPS-Bund spread to widen. Yet, that might not happen during this meeting as the ECB will have to adjust inflation forecasts higher and growth forecasts markedly lower.
Monday, March the 7th
Tuesday, March the 8th
Wednesday, March the 9th
Thursday, March the 10th
Friday, March the 11th
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Head of Fixed Income Strategy