Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Fixed income market: the week ahead
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The message coming from the bond market is clear: a new tightening cycle has begun, but it won't last for long. The short part of the yield curve rises because the Federal Reserve has hiked interest rates in money markets. Nevertheless, plunging yields in the long part of the curve signal that a lingering economy might force the central bank's hand to turn back on its hawkish stance. We expect the yield curve to continue to bear-flatten this week amid Powell's speech tomorrow and the release of personal consumption expenditures data on Thursday. This week's 2-, 5- and 7-year US Treasury auctions will be pivotal as weak demand might reveal that the market is expecting earlier interest rate hikes than what the Fed signalled. We anticipate the 2s10s and 5s30s spreads to fall to test their support at 100bps. The Bank of England will most likely keep monetary policies unchanged and reiterate that inflation will be transitory. However, in the long run, Gilts will remain vulnerable to yields rises in the US and growing inflationary pressures.
Fasten your seat belts: the new tightening cycle has begun
We are entering another pivotal week for markets. Fed Chairman Jerome Powell testifies before Congress tomorrow after he signalled that the central bank is considering tapering its purchases of mortgages and US Treasury bonds. Additionally, we will get the Federal Reserve's preferred inflation measure on Thursday: personal consumption expenditures data (PCE). A surprise in these numbers could move the market in light of the Fed's reversal on easy monetary policies enforced since the Covid crisis.
The signal coming from the bond market can be confusing. Indeed, the FOMC meeting provoked a selloff in US Treasuries, pushing 10-year yields as high as 1.59%. However, by the end of the week, yields dropped to 1.43%. Today, the yield on US Treasuries opened at the lowest level since February despite a hawkish Fed meeting and the highest CPI readings since the Global Financial Crisis. The yield curve has flattened sharply, with short-term yields rising fast while long-term yields were falling.
We believe that yields tell investors that a new tightening cycle has already started with the Fed signalling the beginning of both tapering and interest rate hikes. Indeed, while the market focused on the announcement of the beginning of tapering talks, Powell was able to deliver a light interest rate hike in disguise. The central bank hiked by five basis points the overnight reverse-repurchase agreement facility (RRP) to 0.05% and interests paid on excess reserve to 0.15%. The move was branded as a “technical adjustment” yet, the fast flattening of the US yield curve suggests the real nature of this action: an interest rate hike. Indeed, although a rise of 5 basis points can seem minor, we cannot forget that the market depends on low-interest rates like never before in history. A five basis points hike in money markets where yields are near zero or even negative it's a real game-changer. The day that the new rate regime was implemented, demand for the Fed’s reverse-repo facility rose from around half a trillion to a new record of three-quarters of a trillion dollars.
While the US yield curve was undergoing a massive flattening, breakeven rates were dropping too. That’s quite an understandable move because if the central bank is planning to pull stimulus from the system, inflation is expected to subside as well. Yet, the correction was quite abrupt, with 5-year Breakevens falling to 2.37%, roughly 40bps down from their peak in May. The 5-year 5-year forward plunged to 2.11%, a drop of 30bps from a month ago. We believe that with the breakevens adjusting so suddenly and long-term yields falling too, the bond market is telling us that the Federal Reserve may not be able to keep up with their tightening cycle as growth may lag and inflation should normalize, forcing the central back into a new era of accommodative measures.
Yet, that is a dangerous position to take because there are no signs that inflationary pressures are transitory. While commodities might have peaked, there are still many core price pressures that might have not. Additionally, nothing is telling us that the Federal Reserve will be able to control inflation. Thus, the whole yield curve remains at risk until the transitory nature of consumer prices isn't sure.
Yet, in the immediate future, we can expect the front part of the yield curve to be much more sensitive to inflation expectations and tapering talks. That’s why if Thursday’s PCE index surprises on the upside, we might see short-term yields shifting even higher while long-term yields will stay stable. Ahead of inflation data, we will have the US Treasury issuing 2-, 5- and 7-year Treasuries starting from tomorrow. These maturities are highly vulnerable in light of the recent reversal of monetary policies and short-term inflation expectations. If bidding metrics are week, we could see a further flattening of the yield curve, pushing both the 5s20s and 2s10s spreads to test support at 100bps.
Suppose the yield of 2-year US Treasury bonds rises amid weak demand at tomorrow's auction. In that case, it may be a signal that the market is expecting earlier interest rate hikes than 2022. Last week, 2-year yields rose to 0.27% and stabilized at 0.25% for the first time since April 2020, the high end of the Federal Reserve target fund rate.
The Bank of England will wrongly dismiss increasing inflationary pressures
This week marks the last monetary policy meeting for Andy Haldane, the BoE's chief economist who's leaving to become chief executive of the Royal Society for Arts, Manufactures and Commerce (RSA). So far, he has been the only advocate of an elevated risk of inflation in the country. Last week’s CPI numbers have agreed with his view that inflation in the United Kingdom might be a completely different game from elsewhere. Indeed, Brexit may serve as a multiplier of inflationary force, adding more pressures on specific bottlenecks such as transportation and the labour market. While transportation issues will provoke higher prices on certain goods that now will find it hard to make it to the country, a much tighter labour market might provoke higher wages, which will be a stickier factor of increasing prices.
However, the Monetary Policy Committee will likely leave monetary policies unchanged in light of a delayed reopening of the economy. The minutes of the meeting might also reiterate that inflation will be transitory.
Within this context, Gilt yields will continue to trade rangebound between 0.70% to 0.85%. However, inflationary data and the direction of US Treasury yields are critical to Gilts' performance. If US long-term yields resume to rise and inflationary pressures continue to grow, we can expect Gilt yields to increase fast to 1%.
Economic calendar:
Monday, the 21st of June
- Australia: Retail Sales
- Germany: Buba Monthly Report
- Eurozone: ECB President Christine Lagarde Speaks
- United States: 3- and 6-Month Bill Auction, Fed’s Williams speech
Tuesday, the 22nd of June
- New Zealand: Westpac Consumer Survey
- Italy: Industrial Sales
- United States: Redbook, Existing Home Sales, Richmond Fed Manufacturing Index, 2-year Note Auction, Fed’s Chair Powell Testifies before Congress
- Eurozone: Consumer Confidence
Wednesday, the 23rd of June
- Australia: Commonwealth Bank Services, Manufacturing and Composite PMI
- Japan: BoJ Monetary Policy Meeting Minutes, Leading Economic Index
- Eurozone: Non-Monetary Policy ECB Meeting
- France: Markit Manufacturing, Services and Composite PMI
- Germany: Markit Manufacturing, Services and Composite PMI
- Eurozone: Markit Manufacturing, Services and Composite PMI
- United Kingdom: Markit Manufacturing, Services and Composite PMI
- United States: Markit Manufacturing, Services and Composite PMI, 5-year Note Auction, New Home Sales
- Canada: Retail Sales
Thursday, the 24th of June
- Japan: Foreign Investment in Japan stocks, Foreign Bond Investment, BoJ’s Governor Kuroda Speech
- Eurozone: European Council Meeting, Economic Bulletin
- Germany: Import Price Index, IFO Business Climate, Current Assessment, Expectations
- France: Business Climate in Manufacturing
- Spain: Gross Domestic Product
- United Kingdom: Bank of England Monetary Policy Meeting and Interest Rate Decision
- United States: Personal Consumption Expenditures (QoQ), Durable Goods Orders, Gross Domestic Product, Initial Jobless Claims, 7-year Note Auction, Bank Stress Test Info
Friday, the 25th of June
- New Zealand: Trade Balance
- Japan: Tokyo Consumer Price Index
- Eurozone: European Council Meeting, Private Loans, M3 Money Supply
- Germany: Gfk Consumer Confidence Survey
- Italy: Business and Consumer Confidence
- United Kingdom: BOE Quarterly Bulletin
- United States: Core Personal Consumption Expenditures – Price Index, Personal Income, Personal Spending, Michigan Consumer Sentiment Index
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