Senior Fixed Income Strategist
Summary: This week’s FOMC meeting will dictate sentiment in markets globally. We believe that information concerning the balance sheet reduction is crucial to understand how many rate hikes the Fed is likely to implement this year. It will also give a better picture of whether the yield curve will continue to bear-flatten or if there is potential for a slight steepening. Yet, concerns regarding a slowdown in growth and escalation of tensions between the US and Russia are likely to keep long-term yields compressed, hindering the rise of 10-year yields to the pivotal 2%. In Europe, investors' focus will be on Italian BTPS as the country's parliament will gather to elect the republic's new President. We expect volatility to rise in the process, draining demand for Italian BTPS and causing a widening of the yield curve up to 160bps.
This week's Federal Reserve meeting will dictate sentiment across assets. The market is waiting for indications regarding interest rate hikes for this year and hearing what intentions the central bank has concerning reducing its nearly $9 trillion balance sheet.
Currently, the market is pricing four interest rate hikes this year, starting in March. The big question is whether the Fed will match, disappoint or exceed such expectations. We see three outcomes playing out this week:
Of all the options above, I believe the last one to be the most probable. Indeed, the central bank has shown concerns regarding the current flat shape of the yield curve on several occasions. Therefore, it wouldn’t make sense to see an overly aggressive Powell vowing for a fast pace of rate hikes because that would rapidly flatten the yield curve.
It’s more probable that the Federal Reserve would seek to combine interest rate hikes with an early and gradual reduction of its balance sheet to preserve the yield curve's steepening on one side and to tighten the economy more efficiently on the other. By implementing balance sheet policies, the central bank will affect long-term yields directly linked with mortgage and borrowing costs. However, if the Fed were to hike rates by 50bps in March, as some have suggested, it will have little impact on supply-chain bottlenecks or energy prices.
Suppose Powell looks more inclined to combine interest rate hikes with a balance sheet reduction on Wednesday. In that case, the market might reconsider the number of hikes for 2022 because the central bank might not need to be as aggressive as expected.
Yet, we have to be prepared for a year where the Federal Reserve might move and change messages at each meeting. While last year the officials were patiently trying to prove that inflation was transitory, this year, they are pressured by the White House and its constituents to fight it. Thus, prepare for a volatile year in markets.
Economic data are also going to be pivotal for the week ahead. The US will release preliminary data on last quarter's gross domestic product on Thursday. Data on personal income and spending for December will also be released on Friday. Both data might show that the economy is losing momentum, adding to worries concerning a slowdown in growth that could keep long-term yields compressed.
We cannot finish talking about Treasuries without mentioning the escalation of geopolitical tensions between the US and Russia, which provoked a fast drop of yields across the yield curve on Friday. If tensions escalate, we can expect yields to remain compressed or even dropped amid a flight to safety.
Today, yields have fallen further, with 10-year yields close to testing resistance at 1.70%.
In Europe, the move of US yields will be a central focus. If they resume their rise, they could provide momentum for Bund yields to break once again above 0% and remain above this level.
Gross domestic product data for the fourth quarter of 2021 for Germany, France, and Spain will be released on Friday, while PMI figured will be coming out today.
Today, the Italian parliament has gathered to vote for the next President of the Republic. Today, I will not go into the details of each scenario. What is important to know is that such an election is likely to spur volatility among Italian government bonds. A rise in volatility has historically been linked to decreasing investors' appetite for bonds from the periphery. In the most conservative scenario, we see a temporary widening of the BTP-Bund spread to 160bps. However, if Draghi leaves his job as PM, the country is risking a political vacuum, leading to an early election. Not only, but Italy's recovery also depends on the funds of the NextgernerationEU fund that will not be disbursed unless the PM will implement necessary reforms. Therefore, the loss of Draghi as PM could be costly, and in the worst-case scenario, the BTPS-Bund spread could widen over 200bps.
Yet, it's important to highlight that we remain bullish the BTPS-Bund spread in the long term. Indeed, both the ECB and the new German government are invested in a better integrated Europe, which in the long run is likely to provoke spread compression across the euro area.
Monday, January the 24th
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