Senior Fixed Income Strategist
Summary: Central banks are divided between an uncertain economic outlook and intense inflationary pressures. These conflicting elements keep government bonds from benefitting from safe-haven demand fully. That's why this week, investors will focus on ECB and Federal Reserve's speakers as it’s key to understand how central banks will position under these circumstances. We are still concerned about the US and European junk bond space as the primary market remains frozen amid the sudden rise of volatility. We believe that the signs of a tantrum in credit markets are increasing and that it will be hard to be avoided by central banks.
Uncertainty in markets is exceptionally high as geopolitical tensions escalate and harsher sanctions are imposed on Russia. The bond market has the challenging task of assessing risks coming from an uncertain economic outlook and high inflationary pressures. War in Ukraine will bring higher energy prices and squeeze household spending, making the job of developed central banks even more challenging than the market expected.
While before Russia invaded Ukraine, a Federal Reserve's rate hike in March was a done deal, now the market begins to have doubts. The probability for a 50bps rate hike has fallen sharply, and money markets have started to give some signals that even a 25bps hike might prove challenging. This morning the FRA/OIS spread opened roughly 10bps above Friday's close on the news that new sanctions will exclude a large part of Russian banks from the SWIFT messaging system. The implication of such sanctions might be far-reaching. Credit Suisse money market guru Zoltan Pozsar explains that it could result in missed payments and force the Fed to increase the money supply. He says that roughly $300 billion of foreign currency is held offshore by Russia, enough to disrupt money markets if frozen by sanctions. In a nutshell, the only way to keep financial markets' stability might be for the Fed's balance sheet to get bigger and slow down its interest rates hiking agenda.
Therefore, the safe-haven bid sovereign bonds benefit from might be strengthened as markets are forced to pare back on rate hikes expectations.
The bond market will listen carefully to what central bank officials will have to say regarding inflation and the economic outlook. Bostic, Mester, Evans, Bullard, and Williams will all speak throughout the week in the US. However, the focus will be on Jerome Powell speaking in front of the House Committee on Financial Services on Wednesday and before the Senate Banking Committee on Thursday. In Europe, Panetta, Lagarde, Guindos, Lane, and de Cos will speak before the blackout period starts on Thursday in conjunction with the release of the ECB minutes.
It's key for markets to understand whether inflation or growth will be given priority. That choice could have severe consequences in the bond market. If central banks sound too hawkish, a tantrum might ensue within risky assets as yield curves will bear flatten. If central banks are instead dovish, the yield curve might steepen as markets pare back rate hikes expectations. However, a tantrum might just be postponed if volatility doesn't normalize due to the escalation of geopolitical tensions.
Despite volatile markets, investors will be looking at data coming from Europe and the US. In Europe, the focus is on the CPI numbers, expected to show a yearly increase of 5.6% in February. The focus will be on nonfarm payrolls and particularly on average hourly earnings in the US, which gives a picture of wage inflation. Yet, depending on how things evolve in Ukraine, these data might not provoke a strong market reaction, as priority will be given to March's monetary policies announcements expectations.
In the short term, it’s safe to expect real rates to continue their fall as breakeven rates rise and nominal rates drop. Yet, dropping real rates might not work in support of credits as they did in the wake of the Covid pandemic. Volatility in markets is causing corporate bond spreads to widen sensibly and freezing the primary market. Investment-grade corporates can still borrow in the primary market. Still, there is no pipeline for high-yield deals, signaling that investors remain wary of credit risk amid high inflation and escalating geopolitical tensions. The only junk bond deal to have been priced in the US since the 10th of February has been Twitter. However, I don't consider it a bellwether for the high yield space, as Twitter is a well-known name, attracting a lot of attention. The real test for the junk bond space would have been the issuance of 10y bonds from BellRing Brands, which should have come through the following day, but was canceled due to the Russian invasion of Ukraine. Since then, the junk bond primary market has been completely paralyzed with no signal of upcoming deals. The same can be said about the European high yield bond space, which didn’t see a junk bond priced since the 16th of February.
Before the war in Ukraine, a slowdown in junk bond issuance was attributed to central banks' tightening agenda. However, now, risk aversion has taken a leading role. Suppose the war continues while central banks signal the need to tighten financial conditions regardless. In that case, it's a matter of time before a tantrum ensues.
According to a Bloomberg report, Russia's credit swap signals a 56% chance of default on sanctions. This morning, the Russian market was paralyzed with investment banks quoting huge spreads on Russian corporate bonds such as Gazprom. Investors start to fear that banning Russia from SWIFT means that any position in Russian assets will be completely frozen. In the case of corporate bonds, it could mean that it will be challenging to receive coupon payments from Russian bonds.
Monday, February the 28th
Tuesday, March the 1st
Wednesday, March the 2nd
Thursday, March the 3rd
Friday, March the 4th
Bond. Long Bond(s)
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