Head of Fixed Income Strategy
Summary: Last week ECB's meeting changed the rule of the game: monetary policies will now focus on inflation while fiscal policies will have to take care of growth. That is even more true for the Federal Reserve, which is well behind the curve in tightening monetary policy while inflation expectations continue to soar. That's why the market is positioning for a hawkish FOMC meeting this Wednesday, which might combine a rate hike with an announcement concerning the runoff of the Fed’s balance sheet or an aggressive dot plot. Investors will also look at the BOE and BOJ for signs of hawkishness. In the meantime, interest payments of Russian eurodollar bonds are approaching, and the market is wondering whether the country could default.
Several central banks are meeting this week for their monetary policy decision. Yet, the big event everybody is waiting for comes on Wednesday, when the FOMC meeting will decide to hike interest rates for the first time since before the Covid pandemic. Before commenting on markets and what to expect on Wednesday, I believe it is crucial to consider last week’s events as they provide a critical framework for what might happen next.
The market was expecting the ECB to remain dovish last week amid the uncertainty produced by the war in Ukraine. Investors were confident that the central bank would be more concerned about a slowdown in growth rather than inflation. However, they were wrong. Lagarde's message was clear: monetary policies will fight inflation, but growth will need to be taken care of by fiscal policies. That is a massive change from the ECB's message during the pandemic era, which focused on supporting the bloc’s economy.
If it weren’t enough, the central bank clarified that QE is finishing earlier than previously indicated. The Governing Council will conclude net purchases under the APP during the year's third quarter. The ECB will not be around to pick up the bill for higher defense and energy spending schemes. That implies bond yields will continue to surge despite the war's uncertainties.
Yet, news of a possible EU joint bond issuance to finance energy and defense spending helped limit the widening of European sovereign spreads. Despite such news building the case for a much better EU monetary and fiscal integration, it's critical to remember that such decisions are usually not rushed through. During the Covid pandemic, it took nearly six months for members to agree on the NextGenerationEU package. Therefore, until we don't have information regarding an imminent agreement, support for the periphery can wane quickly, contributing to more short-term spread widening.
Anything is possible during Wednesday's FOMC meeting, given the recent hawkish twist of the ECB. Jerome Powell recently said that he's going to vote for a 25bps rate hike at this meeting, but he doesn't exclude a 50bps rate hike in the future, if necessary.
Today, the market is positioning for a much more aggressive Federal Reserve meeting as inflation expectations continue to soar. Nominal yields are also rising, with the 10-year yields breaking above 2.10% for the first time since July 2019. It seems that the market is preparing for an escalation of the ECB meeting. The Federal Reserve will focus merely on inflation from now on, leaving concerns regarding a slowdown in growth to fiscal policies.
A 25bps rate hike might not be enough if that were the message. Fed officials might want to combine their rate hike with an aggressive dot plot or an announcement surrounding the Fed's balance sheet's runoff (or both). Either way, volatility might increase dramatically. This week, the market lacks the life support provided by purchases under the Fed's QE program, which ended last week.
The FOMC meeting will surely make the headlines this week. However, it's critical to continue to look for news from the primary corporate bond market. Syndication desks are looking to issue $30 billion worth of high-grade bonds ahead of the Fed meeting. In contrast, the junk bond primary market remains choppy. If volatility further restricts bonds issuance, that would indicate that we are approaching tantrum levels.
The debate on whether Russia will default or not on its debt continues. The Credit Derivatives Determination Committee clarified that payment in rubles for the six bonds the committee examined wouldn't constitute a default. Such a decision could delay a Russian default. However, two dollar-denominated bonds, which interest payment is also due this week, do not allow for payment in rubles. It isn't clear whether Russia will be paying interest on these bonds in US dollars or not. According to Putin’s decree, investors in hostile countries will receive payment in rubles. In contrast, those in friendly countries might still receive a payment in US dollars. If that were to happen, not only would Russia break the bond agreement, but it would break the "pari passu" clause, which requires bond sellers to treat investors fairly and equally.
It's important to highlight that even if Russia misses a payment this week, it would be deemed a default only after a 30-day grace period. Therefore, we might not have the answers we are looking for until a few weeks.
Monday, March the 14th
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Friday, March the 18th
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