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: This week's US CPI numbers are in the spotlight as they might give further reasons to the Federal Reserve to accelerate the pace of tapering during the next FOMC meeting. Therefore, we continue to see scope for a bear flattening of the yield curve. Long-term yields will continue to remain compressed as uncertainties surrounding omicron persist together with growth concerns. At the same time, the front part of the yield curve will continue to be vulnerable to the Federal Reserve's less accommodative monetary policies. This week's 3-year, 10-year, and 30-year US Treasury auctions will also be in the spotlight. In the UK, investors should focus on rate hike expectations and how likely it is for the BOE to deliver a 10bps rate hike in December. If the central bank disappoints, the market will need to reconsider rate hikes expectations for 2022, which will provoke lower yields in the front of the yield curve.
Last week’s flattening of the yield curve has been impressive. The 2s10s spread fell by 21.77bps, the largest drop since June 2012, when the monthly job report missed expectations and pessimism over long-term growth caused 10-year yields to drop to 1.38%.
One could quickly jump to the conclusion that the flattening of the yield curve, in this case, was also provoked by a nonfarm payrolls miss. Yet, that would be inaccurate as it doesn't take into consideration the overall picture. Although the monthly job data was weaker than reported, the unemployment rate fell substantially, dropping to 4.2%, while the market expected it to fall to 4.5% from 4.6% a month earlier. In construction, manufacturing, and business and professional services, unemployment rates are now well below pre-covid levels. Jobs in leisure and hospitality are still lagging as omicron is hitting the economy, and business travel is not at the same level as pre-pandemic.
Additionally, the job miss this month might not be as bad as it looks. Indeed, this year's revisions of nonfarm payrolls have not been minor, and they have often turned a slump into a surprising surge. For example, August’s nonfarm payroll big miss was revised by more than double, with the largest positive revision in almost forty years. Similarly, when the economy added only 194,000 jobs in September, the revision showed that the correct number was 312,000.
Thus, the Federal Reserve might feel behind the curve. The job market is recovering faster than expected, supported by a wage surge, which ultimately will feed inflation further. That's why inflation has suddenly become the central bank's focus, and hawkish and dovish members agree that a faster taper pace is necessary.
Although the Federal Reserve has tried to decouple tapering from interest rate hikes expectations, it failed to do so. That's why as the market expects a faster pace of tapering, short-term yields will soar. On the other end, the long part of the yield curve is dropping as the market anticipates slower growth, caused partly by covid and partly by interest rate hikes expectations. However, it might still change in light of this morning's cut of the reserve requirement ratio in China. The news report that China will keep liquidity at an ample level to support small and medium enterprises. It signs the beginning of a monetary easing cycle to counter the economic slowdown, which could benefit growth globally.
Therefore, the long part of the yield curve looks too rich and depends on growth estimations and the omicron variant. Those variables are crucial to keeping yields at current low levels. However, as we approach the end of tapering, the Federal Reserve will begin to discuss interest rate hikes, putting upward pressure on the whole yield curve, including long-term yields. Therefore, it is safe to expect a yield curve flattening during the next couple of months, accentuated by low long-term yields. Yet, as we approach interest rate hikes, long-term yields will also need to move higher towards our 2% target.
Demand for US Treasuries continues to be critical. Hence this week 3-year, 10-year, and 30-year US Treasury auction will be in the spotlight.
Gilts: are interest rate hikes in the UK ahead of themselves?
The focus will be on the October GDP figures released on Friday. UK growth is expected to soften in October to 0.4% compared to the jump of 0.6% in September. Yet, the biggest challenge the market will be facing concerns rate hikes expectations. Indeed, the market has been pricing four rate hikes next year, which is a much more aggressive rate hike cycle compared to other developed economies. A 10bps rate hike is estimated to be delivered already at the next BOE meeting. However, Michael Saunders on Friday said that he would need to think twice about voting for a rate hike this month. These comments come from the most hawkish member on the MPC, putting in doubt that a rate hike is on the card at all. If a rate hike is not delivered, the market might need to reconsider rate hikes expectations for 2022, provoking yields in the front part of the yield curve to drop.
Economic calendar
Monday, December the 6th
- Italy: Retail Sales (Oct)
- United Kingdom: Construction PMI (Nov), BoE Broadbent Speech
Tuesday, December the 7th
- Australia: Ai Group Services Index (Nov), Building Permits MoM Final (Oct), RBA Interest rate Decision
- Japan: Household Spending YoY (Oct), 30-year JGB Auction, Coincidence Index Prel (Oct)
- United Kingdom: BRC Retail Sales Monitor YoY (Nov), 30-year Treasury Gilt Auction
- China: Balance of Trade (Nov)
- Netherlands: Inflation Rate (Nov)
- France: Balance of Trade (Oct)
- South Africa: GDP Growth Rate (Q3)
- Eurozone: GDP Growth Rate 3rd Estimate (Q3), ZWE Economic Sentiment Index (Dec)
- Germany: ZEW Economic Sentiment Index (Dec), 2-year Schatz Auction
- Spain: Consumer Confidence
- Canada: Balance of Trade (Oct), Ivey PMI s.a.
- United States: Balance of Trade (Oct), Consumer Credit Change, 3-year Note auction
Wednesday, December the 8th
- Japan: GDP Growth Annualized Final (Q3), Bank Lending YoY (Nov), GDP Growth Rate QoQ Final (Q3), Eco Watchers Survey Outlook (Nov)
- Germany: 10-Year Bund Auction
- United States: MBA Mortgage Application, MBA 30-year Mortgage Rate, MBA Mortgage Market Index, MBA Mortgage Refinance Index, JOLTs Jon Openings (Oct), JOBs Job Quit (Oct), 10-year Bond Auction
- Canada: BoC Interest Rate Decision
Thursday, December the 9th
- Australia: RBA Gov Lowe Speech, RBA Bulleting
- Japan: BSI Large Manufacturing QoQ (Q4), Foreign Bond Investment
- China: Inflation Rate YoY (Nov), PPI YoY (Nov)
- Germany: Balance of Trade (Oct)
- Ireland: Harmonized Inflation Rate (Nov)
- United States: Continuing Jobless Claims, Initial Jobless Claims, Jobless Claims 4-week Average. Wholesale Inventories MoM (Oct), 30-year Bond Auction
Friday, December the 10th
- New Zealand: Business NZ PMI (Nov), Electronic Retail Card Spending (Nov)
- Japan: PPI (Nov)
- Germany: Inflation Rate Final (Nov)
- United Kingdom: GDP (Oct), Balance of Trade, Construction Output (Oct), Goods Trade Balance (Oct), Industrial Production (Oct), Manufacturing Production (Oct), NIESR Monthly GDP tracker (Nov)
- Italy: Industrial Production (Oct)
- United States: Inflation Rate (Nov), Michigan Consumer Sentiment Prel (Dec), Michigan 5-year Inflation Expectations Prel (Dec), Michigan Current Conditions Prel (Dec), Michigan Inflation expectations Prel (Dec), Monthly Budget Statement
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