A painful path to normalisation A painful path to normalisation A painful path to normalisation

A painful path to normalisation

Althea Spinozzi

Senior Fixed Income Strategist, Saxo Bank Group

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. 

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. 

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.  

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. 

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)

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

Support Centre
For existing clients, please click here to request support via the Support Centre.

Have a question about our products, platforms or services? Visit the Support Centre to find answers for our most frequently asked questions. If you are still unable to locate an answer to your question, you will also find contact details for your local Saxo office to speak with a representative.

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 Markets is a registered Trading Name of Saxo Capital Markets UK Ltd (‘SCML’). SCML 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.

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 Markets 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.