A painful path to normalisation
Senior Fixed Income Strategist
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 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 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 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 Federal Reserve will not stop until it has inflation under control
Since the beginning of the year, US Treasuries have suffered from the most significant losses compared to any year 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 a massive headache for the Federal Reserve, which originally envisioned tightening the economy in an expansion as inflation was peaking. Right now, it's difficult to say when inflation will be peaking, while it’s inevitable that the economy will slow down. The Federal Reserve 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 this time around. Indeed, inflation expectations in the US have recently soared to record new levels across the curve, showing that high inflation is becoming more entrenched than initially thought.
However, fighting inflation is not as straightforward as one might think. Although a supply shock has produced the inflation we are experiencing now, the Federal Reserve only has the power to limit demand. Even so, 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 uncertainties 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 in the near future.
That’s why we believe that sooner rather than later, the Fed will 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 part of the yield curve rather than the long part, 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 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 way behind the curve compared to the Federal Reserve, the euro currency 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 that this time around, the ECB will not be there to digest countries’ debt binge as it did in the wake of the Covid pandemic. Therefore, volatility in the rates market will 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 that 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 against a 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 learned during the Covid-19 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.
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