Quarterly Outlook
Macro Outlook: The US rate cut cycle has begun
Peter Garnry
Chief Investment Strategist
The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
Fixed income market: the week ahead
Althea Spinozzi
Head of Fixed Income Strategy
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.
A critical week for US Treasuries.
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:
- The Fed matches the market's expectations. In this case, investors' focus would shift towards the drawdown of its balance sheet. Suppose there are indications that the Fed’s balance sheet needs to be shrunk faster compared to previous tightening periods due to inflationary pressures. In that case, we could witness a selloff concentrated in long-term Treasuries and assets with high duration, such as Tech stocks.
- The Fed exceeds the market's expectations. We believe it to be the least likely scenario. In this case, we will witness a fast bear-flattening of the yield curve as the market will need to price a more aggressive rate hike schedule.
- The Fed disappoints the market's expectations. In this case, we might see the yield curve bull-steepening as the front part of the yield curve will need to reconsider the number of interest rate hikes this year. Wording concerning the balance sheet reduction will be critical as an early and aggressive start of its wind-down could lift long-term yields, steepening the yield curve further.
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%.
Europe yields stall their rise.
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.
Italian parliament starts with the presidential elections.
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.
Economic calendar
Monday, January the 24th
- Australia: Commonwealth Bank Composite PMI (Jan), Commonwealth Bank Manufacturing PMI (Jan), Commonwealth Bank Services PMI (Jan)
- France: Markit Manufacturing PMI (Jan), Markit PMI Composite (Jan), Markit Services PMI (Jan)
- Germany: Markit Manufacturing PMI (Jan), Markit PMI Composite (Jan), Markit Services PMI (Jan)
- Eurozone: Markit Manufacturing PMI (Jan), Markit PMI Composite (Jan), Markit Services PMI (Jan)
- United Kingdom: Markit Manufacturing PMI (Jan), Markit Services PMI (Jan)
- United States: Chicago Fed National Activity Index (Dec), Markit Manufacturing PMI (Jan), Markit PMI Composite (Jan), Markit Services PMI (Jan), 3-month and 6-month Bill, 2-year Note Auction
Tuesday, January the 25th
- Australia: Consumer Price Index (Q4), RBA Trimmed Mean CPI (Q4)
- Germany: IFO – Business Climate (Jan), IFO – Current Assessment (Jan), IFO – Expectations (Jan)
- United States: Consumer Confidence (Jan), Richmond Fed Manufacturing Index (Jan), 5-year Note Auction
Wednesday, January the 26th
- New Zealand: Trade Balance
- Japan: BoJ Summary of Opinions
- Germany: 10-year Bond Auction
- United States: Goods Trade Balance (Dec) prel, New Home Sales (Dec)
- Canada: Bank of Canada Monetary Policy Report, BoC Interest Rate Decision, BoC Rate Statement, and Press Conference
- United States: Fed Interest Rate Decision, Fed’s Monetary Policy States, FOMC Press Conference
Thursday, January the 27th
- New Zealand: Consumer Price Index (Q4)
- Japan: Foreign Bond Investment, Foreign Investment in Japan Stocks
- Australia: Westpac Leading Index, Export and Import Price Index
- Germany: Gfk Consumer Confidence Survey (Feb)
- Switzerland: Trade Balance
- Spain: Unemployment Survey
- Italy: Industrial Sales
- United States: Core Personal Consumption Expenditures, Durable Goods Orders (Dec), Gross Domestic Product Annualized (Q4), Initial Jobless Claims, Non-defence Capital Goods ex Aircraft (Q4) prel, Personal Consumption Expenditures Prices (Q4) prel, Pending Home Sales (Dec), 4-week Bill Auction, 7-year Note Auction
Friday, January the 28th
- Japan: Tokyo Consumer Price Index (Jan),
- Australia: Producer Price Index
- France: Gross Domestic Product (Q4) prel, Consumer Spending (Dec), Producer Prices
- Switzerland: KOF Leading Indicator (Jan)
- Italy: Business Confidence (Jan), Consumer Confidence (Jan)
- Eurozone: M3 Money Supply (Dec), Business Climate (Jan), Consumer Confidence (Jan), Economic Sentiment Indicator (Jan), Industrial Confidence (Jan), Services Sentiment (Jan)
- United States: Core Personal Consumption Expenditures (Dec), Personal Income (Dec), Personal Spending (Dec), Michigan Consumer Sentiment Index (Jan)
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