Head of Fixed Income Strategy
Summary: Central banks are realising that over a year of aggressive monetary policies might not have been enough to fight inflation. Financial conditions remain loose, governments continue to implement expansionary fiscal policies, and the economy is not decelerating at the expected pace. There is more tightening to do, which will continue to drive yield curves to a deeper inversion in the third quarter of the year. However, additional interest rate hikes might not work as intended. That's why policymakers must consider the active disinvestment of central banks' balance sheets to lift yields in the long part of the yield curve. As the hiking cycle approaches its end, the corporate and sovereign bond markets will provide enticing opportunities in the front part of the yield curve.
Central banks face a troubling dilemma: should they burst the bubble created by more than a decade of Quantitative Easing (QE), or are they able to fight inflation without doing that?
Hiking interest rates by 500bps in the United States and 400bps in Europe has not done the job as central bankers hoped. The job market remains solid, and inflation is stubbornly sticky and well above central banks’ 2% target. All developed central banks have done so far is to drive yield curves to inversion. While an inverted yield curve puts cash-strapped companies at risk, bigger corporates continue to take advantage of lower yields in the long part of the yield curve. Amazon can raise debt at 4.5% and invest at more than 5% in short-term bills. It doesn’t take much to understand that such a rate environment would create the wrong incentives. The dream that fighting inflation won’t mean putting financial stability at risk is adding to the existing bubble.
Overall, financial conditions remain loose. The Chicago Fed adjusted national financial conditions index is negative, indicating that financial conditions are looser on average than would be typically suggested by current economic conditions. Similarly, the real Fed Fund rate has turned positive at the end of March for the first time since November 2019, reaching a restrictive posture only one year and 500bps rate hikes later. The ECB, on the other hand, is markedly behind the curve with the real ECB deposit rate in the bottom range it was trading in before Covid, when the ECB was trying to stimulate growth. Yet, governments continue to perpetrate lavish fiscal policies to win the electorate, adding pressure to the dangerous inflationary environment.
Despite being officially ended, quantitative easing and big central banks’ balance sheets remain the core issue to sticky inflation.
The joint balance sheet of the Federal Reserve and the ECB is above $15 trillion. Currently, both central banks are not actively selling their balance sheets as they have chosen not to reinvest part of their maturing securities. Calling such a strategy “Quantitative Tightening” is just a way for them to talk hawkish and act dovish. They know that to fight the inflation boogeyman, long term yields need to rise, and the way to do that is to actively disinvest their balance sheets, which are composed of long-term bonds. The outcome might be the opposite if central banks choose to hike rates beyond expectations. The higher the benchmark rate, the more likely long-term sovereign yields will begin to drop, as markets forecast a deep recession. Such a move would work against the central banks’ tightening agenda.
Thus, it’s safe to expect that the tightening cycle will come to an end in the second half of the year as more interest rate hikes than those expected by markets would just further invert yield curves rather than have a significant impact on inflation.
As the tightening cycle approaches its end, we expect Federal Reserve and ECB officials to begin to talk about balance sheet disinvestments. At that point, yield curves will begin to steepen, driven by the rise of long-term yields. The front part of the yield curve might start to descend, as markets anticipate the beginning of a rate-cutting cycle. However, if interest rate cut expectations are pushed further in the future, there is a chance that they will remain underpinned for a period. Yet, this path is less certain, as it depends on the ability of policy makers to keep rate cut expectations at bay and the capability of the economy to endure periods of higher volatility. It is at this point that we expect the market to rotate from risky assets to risk-free assets, bursting the bubble created by decades of QE.
We expect the first central bank to end the rate hiking cycle to be the Federal Reserve, while the ECB will need to hike a few additional times to bring the real ECB deposit rate further up. The Bank of England might need to hike into the new year, diverging further from its peers.
Income-seeking investors should prepare to identify entry points as central banks’ policy tightening peaks. As we are entering into a volatile environment, balancing duration and credit risk will be pivotal. Moreover, as uncertainty keeps volatility in bond markets elevated, our preference is to keep duration at a minimum.
Short duration markets, which are the most sensitive to central banks’ policies, offer above-average income opportunities. Even if rates rise further in the near future, the yield offered by high-grade bonds is enticing for buy-and-hold-investors. The spread offered by investment-grade corporates with maturity between one to three years over the US Treasuries is 62bps, paying an average yield of 5.04%. According to the Bloomberg US Aggregate Bond Index, that’s the highest yield paid by high-grade bonds with such short maturity since 2007. More strikingly, IG corporate bonds with one to three years’ maturity offered an average yield of 1.8% from 2007 to today.
Similarly, high-grade euro corporates with one to three years of maturity pay 4.43%, the highest yield since the 2011 European sovereign crisis, paying 280bps over the past fifteen years’ average.
The yield offered by corporate bonds in the UK is much higher than in the United States and Europe. Although for buy-and-hold investors further BOE rate hikes might not represent a threat, it’s important to note that credit risk in the UK is higher than anywhere in developed economies due to uncertainty surrounding inflation and future monetary policies agenda. Thus, cherry picking in this space is even more critical.
Recent government bond issuance shows that risk-free alternatives to the corporate bond market or even stocks offer good opportunities. In June, the UK debt management office (DMO) sold five-year notes with a coupon of 4.5% and a yield of 4.932% (GB00BMF9LG83). That’s the highest coupon offered on five-year notes since 2012, and the highest yield since 2008. Similarly, the US Treasury issued two-year notes in June with a coupon of 4.25% (US91282CHD65). Also, the German Bund sold in April (DE000BU3Z005) pays a coupon of 2.3%. That’s quite staggering if we think that a few years ago, it would have paid a coupon of 0%, providing a negative yield to investors.
In an AI economy, increased productivity and job displacement will exacerbate income inequality. It translates into bigger fiscal deficits as governments initiate education initiatives and social safety nets. As unemployment rises and inflation drops, monetary policies will become more accommodative, with the possibility of negative rates becoming the norm. Yet, the new regime will come with increased inflation volatility. To avoid that, policy makers will be incentivised to regulate AI and use it selectively in order not to destroy the real economy, producing milder economic effects.
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
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