Equities: New extremes and a challenging opportunity set
Discover insights on the future of equity markets in Q1 2024 and navigate the potential recession with strategic investment choices.
Head of Fixed Income Strategy
Summary: This week, investors' focus will be on US inflation, the 10-year, and 30-year US Treasury auctions. While US Treasury yields might rise ahead of Wednesday's CPI numbers, it's safe to expect high demand at this week's auctions to limit their rise. Ten-year EUR-hedged US Treasuries are now offering roughly 0.99%, the highest yield in five years. Additionally, there is the chance that this week's 10-year auction prices above 1.8% for the first time since January 2020. European sovereigns will remain vulnerable to the rise of yields in the US and expectations of a less accommodative ECB. Ten-year Bunds are poised to break above 0% and continue to rise throughout 2022.
Welcome to 2022, a year that will prove challenging due to central banks’ tightening agendas.
We have barely started the year, yet US Treasuries already dropped 1.6% last week, the biggest weekly fall since February 2021 and the second-largest since March 2020. The US yield curve bear-steepened slightly with 2-year yields rising nearly 20bps in a week and 10-year yields soaring by 25bps. Ten-year yields broke and sustained above their strong resistance of 1.75%, which was tested a few times in spring 2021. It's critical to note that an acceleration in real yields has driven the sudden rise in yields. Indeed, as the Federal Reserve becomes more aggressive, breakeven rates decelerate. At the same time, nominal yields soar, provoking a faster rise in TIPS yields. It is terrible news for risky assets, which continue to be underpinned by negative real yields but are facing the prospect of more stringent financing conditions.
With 10-year TIPS trading at -0.74%, weaker companies are still not showing signs of distress, and duration exposed assets are taking all the heat. Indeed, while the year-to-date total return of high yield corporate bonds is down 1%, high-grade corporates, which are more exposed to duration risk, plunged 2%. It's safe to expect this trend to continue throughout the year and risky assets to become more sensitive to rising real rates as they break above -0.5%.
Last week’s move contrasts with what we had witnessed at the end of November when yields dropped despite the Fed becoming more hawkish. Not much has changed since then. Yet, the latest FOMC minutes might have proved to investors that the central bank is becoming much more hawkish than expected. The Fed is considering reducing its balance sheet this year with tapering and interest rate hikes to tighten the economy, putting longer maturities at risk.
The message is clear: the central bank is behind the curve, and it needs to be more aggressive. A slowdown in growth might not be enough to tilt the Fed from its tightening path. Last Friday's non-farm payrolls showed intensifying pay pressure to confirm such fears, with average hourly earnings rising by 0.6% in December. Employers have difficulties finding workers, and they have to pay up to get them from competitors. Higher salaries are sticky and contribute to long-term inflation. At the same time, supply-chain bottlenecks are unlikely to resolve until 2023. Therefore, even if inflation moderates this year, it’s safe to assume it will remain sustained.
It's safe to assume that US Treasury yields will continue to rise across the curve, but not at the pace we have seen in the past week. Sustained inflation and aggressive monetary policies will continue to put upward pressure on yields across maturities, especially in the short end. However, when looking at long-term yields, it's key to acknowledge that the more aggressive the Fed becomes, the slower the economic growth. To compress long-term yields further is also the demand for US Treasuries, which should increase as yields get higher. Foreign investors will be compelled to buy US Treasuries now that EUR-hedged 10-year yields offer 0.99%, the most in five years. Not only but, it could be the first time since January 2020 in which a 10-year auction prices above 1.8%.
Therefore, while it’s safe to assume that 10-year yields will move towards 2%, it’s key to acknowledge that they may stabilize around this level.
European sovereigns are also suffering, with 10-year Bund yields quickly approaching 0%. We expect Bunds to break above this level reasonably soon on the back of higher yields in the US and a less accommodative ECB. However, it's fair to expect the rise in yields to accelerate as Covid restrictions ease. To suffer the most will be government bonds from the periphery, especially Italy, which is struggling with the presidential elections.
Monday, the 10th of January
Tuesday, the 11th of January
Wednesday, the 12th of January
Thursday, the 13th of January
Friday, the 14th of January
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