A painful path to normalisation A painful path to normalisation A painful path to normalisation

A painful path to normalisation

Althea Spinozzi

Head of Fixed Income Strategy

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. 


The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
- Full disclaimer (https://www.home.saxo/en-mena/legal/disclaimer/saxo-disclaimer)

Boulevard Plaza, Tower 1, 30th floor, office 3002
Downtown, P.O. Box 33641 Dubai, UAE

Contact Saxo

Select region


Trade responsibly
All trading carries risk. Read more. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

Saxo Bank A/S is licensed by the Danish Financial Supervisory Authority and operates in the UAE under a representative office license issued by the Central bank of the UAE.

The content and material made available on this website and the linked sites are provided by Saxo Bank A/S. It is the sole responsibility of the recipient to ascertain the terms of and comply with any local laws or regulation to which they are subject.

The UAE Representative Office of Saxo Bank A/S markets the Saxo Bank A/S trading platform and the products offered by Saxo Bank A/S.