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.
A silent deterioration of credits is underway.
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.