Senior Fixed Income Strategist
Summary: The energy crunch will have serious consequences on the bond market because it will keep price pressures sustained, eroding the convenience of holding fixed income instruments that offer moderate spreads over their benchmark. High inflation translates into more aggressive monetary policies worldwide, even for central banks - such as the European Central Bank -that have notoriously been more dovish than others. Therefore, it is inevitable that investors will avoid facing the risk of higher rates this year and this will increase market volatility. Yet, in light of solid economic growth, lower-rated credits might prove not to be as vulnerable as high-grade bonds. Indeed, junk carries less duration than the latter, making it more resilient to interest rate hikes. In 2022, investors need to prepare for the pains of a bear bond market, looking to navigate rough waters while keeping an eye on future opportunities.
The ECB is finding itself between two fires: higher inflation and stalling growth. As long as policymakers believe that inflation is not a credible threat, the central bank will keep its monetary policy highly expansionary. However, if inflation does become a likely menace, the ECB will be forced to engage in more restrictive monetary policies. Under the symmetrical inflation framework adopted last summer, inflation needs to average around 2 percent. If it remains persistently above this level, the ECB will be forced by its statute to intervene. Therefore, the central bank’s inflation forecasts for 2023 and 2024 will be in the spotlight throughout the year. Investors will be looking at the energy crisis, supply-chain bottlenecks, and labour wages and supply, which can all contribute to stickier price pressures. In addition, services inflation could increase as Covid restrictions ease, adding further upside pressure to inflation risk despite economists expecting goods inflation to moderate next year.
Policymakers’ positions concerning inflation risk will get more transparent throughout the year. Meanwhile, we can say that monetary policies remain supportive for European credit spreads following December’s ECB meeting. During the latest monetary policy meeting, the central bank confirmed the end of the PEPP program in March while establishing that reinvestments will continue until at least the end of 2024. PEPP “flexibility” was extended to PEPP reinvestments only and not to the APP, as the market had initially expected, although the APP program will be used to transition to the new regime. It will be increased from €20bn per month to €40bn during the second quarter of the year. It will be then reduced to €30bn in the third quarter to return to €20bn by the end of the year. Any change to the mentioned assets purchase plan due to rising inflation could threaten credit spreads.
Things are different for European government bonds, with QE halving this year if the Covid pandemic doesn't worsen. European sovereigns will lose a significant part of the support provided by the ECB in 2020 and 2021, provoking yield curves to steepen. This trend will be particularly true for German Bunds, which we expect to break above 0 percent during the first quarter of the year and rise towards 0.3 percent by the end of 2022. The expansionary fiscal policies of the new German government, thus more Bund issuance, will support the uptrend in long-term Bund yields. However, if the ECB leans towards rate hikes in 2023, the Bund curve would bear-flatten while provoking a widening of the BTP/Bund spread. Ultimately, a big part of the Bund’s performance will come down to how much US Treasury yields rise, given that the correlation between the two is close to 1.
The recently imposed restrictions amid another Covid wave will take a toll on Italy's high growth rates. Additionally, the departure of Mattarella as president of the republic opens up the possibility of another political crisis, which could culminate into a new election if Mario Draghi decides to move to il Quirinale. Therefore, it is safe to assume the BTPS/Bund spread will widen throughout the year, with a significant part of the rise during the first quarter of the year as political uncertainty remains high. In the most bullish scenario, which sees Draghi continue to lead the government as prime minister, the BTP/Bund spread could rise to 160bps. However, suppose the former president of the ECB decides to leave his current role to pursue the presidency; in that case, the BTP/Bund spread is likely to rise to 200bps. It could even briefly break above this level if it comes down to new elections.
However, we remain constructive on the BTP/Bund spread in the long term. Indeed, we do not see the ECB being as aggressive as the Federal Reserve at any point soon, offering some support for European sovereigns. Additionally, spread compression across the euro area is likely to resume as inflation fears lessen. Indeed, the new German government is committed to creating a better integrated Europe. At the same time, the ECB pledges to provide stability to European markets. Therefore, despite the bumpy road ahead for BTPS this year, they remain a compelling investment for real money such as pension funds and insurances.
After a year of calling inflation "transitory," the Federal Reserve is finally catching up to normalise its monetary policy. With the unemployment rate dropping fast below 4 percent at the end of last year, it's fair to expect pre-pandemic unemployment conditions to be reached relatively soon. This leaves the central bank free to focus on more pressing issues such as inflation. Although price pressures are set to moderate this year, there are signs that they could remain sustained and above the Fed’s target for a long time. Wage growth continues to rise, supply-chain bottlenecks are likely to remain a problem until 2023, and productivity growth remains depressed. As political pressures to fight inflation mount, the Federal Reserve has been pushed to change its accommodative posture and turn more aggressive than the market originally forecasted; this has provoked the US yield curve to flatten considerably.
A flat yield curve is a problem for a central bank looking to hike interest rates because it exposes the economy to the risk on an inverted yield curve, which historically has been seen as a strong indication of an upcoming recession. Real yields had never been this low and deeply negative before the Fed began a hiking cycle. It may be why, in an attempt to steepen the yield curve, Fed members discussed reducing the Fed's balance sheet.
Everything points to the beginning of a bond bear market, which will see the US yield curve shifting higher while bear flattening. The short part of the yield curve will continue to rise amid more aggressive monetary policies. The long part of the yield curve will also shift higher, but at a slower pace, as yields remain compressed by a slowdown in growth expectations and an increasing demand for US Treasuries. We expect 10-year yields to find strong resistance at 2 percent and end the year not far from this figure.
Real yields will ultimately drive the rise in nominal yields. Indeed, as the Federal Reserve becomes more aggressive, breakeven rates decelerate. At the same time, nominal yields soar, accelerating the rise in TIPS yields. It is terrible news for risky assets, which currently continue to be underpinned by negative real yields but are facing the prospect of more stringent financing conditions.
Such a move will have profound consequences for the corporate bond space. Assets with high duration, such as investment-grade bonds, will need to be repriced. At the same time, junk bond spreads will widen amid more restrictive financing conditions as real yields approach 0 percent. That’s why we remain conservative and look at the corporate bond space opportunistically. The only way to successfully navigate these markets is to cherry-pick credits while taking the shortest possible duration and hold these bonds until maturity to avoid a capital loss. Although cash is toxic amid a high inflationary environment, it is wise to keep liquid to enter positions as new opportunities arise in the future.
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