QO_Q2_2022_In-platform_1312x480 AltheaF

A painful path to normalisation

Quarterly Outlook
Picture of Althea Spinozzi
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  During the second quarter of the year, the bond market will continue to find itself between a rock and a hard place.


During the second quarter of the year, the bond market will continue to find itself between a rock and a hard place. While the Federal Reserve will actively engage in aggressive monetary policies to curb inflation, geopolitical concerns will add upward price pressures and fears of slower growth. Thus, volatility will remain elevated, causing even more widening of credit spreads. 

The most significant difference between the first and second quarters of 2022 is that while bond yields surged on monetary policy expectations at the beginning of the year, now markets need to consider what central banks will actually do. Policy decisions will not be confined only to interest rate hikes. They will touch upon other tools such as the runoff of their balance sheet, forward interest rate guidance and updating their economic outlook. If central banks disappoint market expectations, the risk of entrenched sustained inflation becomes higher; if central banks overtighten the economy, the risk of a recession increases. 

Whether you want to admit it or not, we have entered a bond bear market, where yields are destined to increase substantially. In this environment, traditional safe havens like US Treasuries will not protect investors looking to diversify portfolios. Duration will be even more toxic than at other times in history because we are starting off from record low interest rate levels and there is no higher income to fall back on. This is a result of years of accommodative monetary policies, which has distorted risk perception and forced investors to take on more risk either through credit or duration. 

Therefore, the chances for a tantrum in credit markets has increased. The good news is that following a dark period of uncertainty and volatility, a new and better equilibrium will be restored, enabling investors to rebuild their portfolios at much better market values. 

The Fed will not stop until it has inflation under control 

Since the beginning of the year, US Treasuries have suffered from the most significant losses since 1974. Their weak performance is attributable to bets on interest rate hikes for 2022. However, the situation has recently become more complex. With the rise of geopolitical tensions, investors have been divided between high inflation and a slowdown in growth.  

That is proving to be a massive headache for the Fed, who originally envisioned tightening the economy in an expansionary environment as inflation ran hot. 

Right now, it's difficult to say when inflation will peak, while it’s inevitable that the economy will slow down. The central bank needs to redirect its efforts to fix one of these two problems. We believe that it will work towards containing inflation at the cost of growth despite inflation expectations soaring to record new levels. 

Q2_2022_AS2

However, fighting inflation is not as straightforward as one might think.  

Although a supply shock has produced the inflation we are experiencing now, the Fed can only limit demand. But even then, it makes sense to intervene with higher interest rates to avoid inflation from rising further. However, higher rates need economic optimism, which is currently being eroded by uncertainty surrounding the energy crisis. Therefore, the strategy of the Fed to focus on interest rate hikes might provoke the yield curve to flatten further or even invert, flagging a recession soon. 

That’s why we believe the Fed will soon need to begin with the runoff of its balance sheet to lift long-dated interest rates. However, it’s critical to acknowledge that in the past, a balance sheet reduction has been synonymous with lower rates in the long term. The best example is the 2018-2019 quantitative tightening (QT): while long-term rates rose initially, as market volatility intensified yields dropped sharply. 

History tells us that central banks are better at controlling the short-end of the yield curve rather than the long-end, as longer-term rates depend on investors' perception of whether the economy can withstand the Fed's tightening path. It won't be different this time around, and the Fed might even need to provoke a recession to get hold of inflation. 

Therefore, our projection is for US Treasury yields to rise across the yield curve in the mid-term, provoking a mild flattening of the yield curve. However, long-term yields might begin to adjust lower not far from the beginning of QT, causing a sudden flattening or even an inversion of the yield curve. 

Q2_2022_AS3

European bond yields will continue to soar, and sovereign spreads will widen  

In Europe, things are going to get worse before they get better. The energy crisis is putting substantial upward pressure on inflation. Thus, the ECB will not maintain an accommodative stance and will be forced to end stimulus early to begin to hike interest rates as soon as September this year. The ECB is running the risk that if it stays behind the curve compared to the Fed, the euro  might devalue further, bringing even more inflation. 

In the meantime, European countries will look to finance their defence and energy spending by increasing their government bond issuance, adding upward pressure on yields. The big problem is, the ECB will not be there to digest countries’ debt binge as it did in the wake of the Covid-19 pandemic causing volatility in the rates market to soar. It will not be unrealistic to see 10-year Bund yields rising to hit our 0.6 percent target while European government spreads widen considerably. 

Besides being politically problematic, a substantial widening of sovereign spreads is also a problem for the central bank's tightening agenda as financial conditions will tighten faster in certain countries than others. We believe the ECB will tolerate such widening until the BPT-Bund spread hits 250bps. At that point, the central bank might need to decide whether to prioritise inflation or growth. 

Fiscal policies at the EU level might help prevent fast widening of sovereign spreads. All EU members share the same energy and defence spending issues, so an EU defence and energy package financed through the issuance of EU joint debt makes sense; it will limit volatility in the European sovereign space, allowing the ECB to focus on inflation. However, as we have learnt during the pandemic, it might take a long time for EU members to reach an agreement, so it’s unlikely that the periphery will benefit from such support during the year's second quarter.  

Q2_2022_AS4

Corporate bonds are under more stress 

It’s unlikely that the widening of corporate bond spreads has ended. As central banks worldwide begin to hike rates real yields will increase, tightening financial conditions further. Even with deeply negative real yields, we are starting to see several red flags coming from the corporate bond space: widening spreads, choppy primary markets and loss of risk appetite from investors. 

As volatility remains sustained, weaker companies will find it more difficult to access the primary bond market, increasing refinancing risk and the risk for a tantrum. 

Q2_2022_AS5

Quarterly Outlook

  • Equity outlook: The high cost of global fragmentation for US portfolios

    Quarterly Outlook

    Equity outlook: The high cost of global fragmentation for US portfolios

    Charu Chanana

    Chief Investment Strategist

  • Commodity Outlook: Commodities rally despite global uncertainty

    Quarterly Outlook

    Commodity Outlook: Commodities rally despite global uncertainty

    Ole Hansen

    Head of Commodity Strategy

  • Upending the global order at blinding speed

    Quarterly Outlook

    Upending the global order at blinding speed

    John J. Hardy

    Global Head of Macro Strategy

    We are witnessing a once-in-a-lifetime shredding of the global order. As the new order takes shape, ...
  • Asset allocation outlook: From Magnificent 7 to Magnificent 2,645—diversification matters, now more than ever

    Quarterly Outlook

    Asset allocation outlook: From Magnificent 7 to Magnificent 2,645—diversification matters, now more than ever

    Jacob Falkencrone

    Global Head of Investment Strategy

  • Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?

    Quarterly Outlook

    Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?

    John J. Hardy

    Global Head of Macro Strategy

  • Equity Outlook: The ride just got rougher

    Quarterly Outlook

    Equity Outlook: The ride just got rougher

    Charu Chanana

    Chief Investment Strategist

  • China Outlook: The choice between retaliation or de-escalation

    Quarterly Outlook

    China Outlook: The choice between retaliation or de-escalation

    Charu Chanana

    Chief Investment Strategist

  • Commodity Outlook: A bumpy road ahead calls for diversification

    Quarterly Outlook

    Commodity Outlook: A bumpy road ahead calls for diversification

    Ole Hansen

    Head of Commodity Strategy

  • FX outlook: Tariffs drive USD strength, until...?

    Quarterly Outlook

    FX outlook: Tariffs drive USD strength, until...?

    John J. Hardy

    Global Head of Macro Strategy

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

None of the information provided on this website constitutes an offer, solicitation, or endorsement to buy or sell any financial instrument, nor is it financial, investment, or trading advice. Saxo Capital Markets UK Ltd. (Saxo) and the Saxo Bank Group provides execution-only services, with all trades and investments based on self-directed decisions. Analysis, research, and educational content is for informational purposes only and should not be considered advice nor a recommendation. Access and use of this website is subject to: (i) the Terms of Use; (ii) the full Disclaimer; (iii) the Risk Warning; and (iv) any other notice or terms applying to Saxo’s news and research.

Saxo’s content may reflect the personal views of the author, which are subject to change without notice. Mentions of specific financial products are for illustrative purposes only and may serve to clarify financial literacy topics. Content classified as investment research is marketing material and does not meet legal requirements for independent research.

Before making any investment decisions, you should assess your own financial situation, needs, and objectives, and consider seeking independent professional advice. Saxo does not guarantee the accuracy or completeness of any information provided and assumes no liability for any errors, omissions, losses, or damages resulting from the use of this information.

Please refer to our full disclaimer for more details.

Saxo
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo is a registered Trading Name of Saxo Capital Markets UK Ltd (‘Saxo’). Saxo is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871. Registered in England & Wales.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.

©   since 1992