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 Federal Reserve is likely to accelerate the pace of tapering, ending it by the first quarter of 2022. Yet, the dot plot might be more important this time as it could show an acceleration of interest rate hikes expectations by FOMC members further out of the curve. That has the potential to cause a bear-steepening of the yield curve before resuming its bear-flattening trend, which will continue to be the dominant move for 2022. The ECB is likely to postpone any major monetary policy decision to the beginning of the next year. If Lagarde doesn't sound dovish enough, there is the risk that European sovereign yields will rise amid fears of fading ECB support. If the BOE doesn't deliver on a 10bps rate hike, there is potential for the market to push back on rate hike expectations for 2022, causing a bull steepening of the Gilt yield curve.
Federal Reserve: the yield curve might bear-steepen before resuming its bear-flattening trend.
We have talked about it a lot, and last week’s CPI numbers leave no doubt: the Federal Reserve cannot hold its dovish stance any longer as there are increasing signs of non-transitory inflation in the economy. Not only, but the full employment mandate is close to being fulfilled, with jobs recovering fast and the unemployment rate dropping below pre-pandemic levels across all sectors except for travel and leisure. Therefore, the continuous stimulus that the economy receives through tapering it’s unnecessary and counterproductive. Hence, it makes sense to increase the pace of tapering to be done with it as soon as possible.
Our expectation is for the Federal Reserve to double the rate of tapering from $15bn to $30bn per month. That way, the central bank will be done with it by the first quarter of 2022, leaving open the possibility for an interest rate hike as soon as May or even in March, if required.
However, an acceleration of the tapering rate will not catch the market by surprise. The dot plot could be more surprising, as it might show an acceleration in interest rate hikes expectations by FOMC members further out of the curve.
Throughout 2021, FOMC participants have increased short-term interest rate hikes projections. Yet, longer-term forecasts continue not to be aggressive, with the dot plot showing only 150bps rate hikes by 2024. As a reference, during the rate hike cycle between 2015 and 2018, the Fed fund target rate rose from 0.25% to 2.50%. It makes the expectations of only 150bps rate hikes seem conservative in an environment characterized by intense inflationary pressures. Indeed, inflation wasn’t an issue six years ago.
Therefore, there is a big chance that the dot plot will show interest rate projections little changed for 2022 and 2023, but they might accelerate in the longer term. Consequently, it’s possible that the US yield curve will bear-steepen before it will resume its bear-flattening trend, which we still believe will be the dominant move for next year.
The Federal Reserve will welcome a steepening of the yield curve. Indeed, the yield curve is the flattest it has been whenever the central bank began to hike interest rates in the past 35 years, except for 1999. However, it’s impossible to draw a parallel as 10-year yields at that point were at 6%.
The ECB is likely to remain neutral.
The ECB continues to be divided between doves and hawks. The first see threats coming from a new Covid pandemic, and the others focus on inflationary pressures. Therefore it is safe to assume that the central bank will remain neutral and postpone any big decision to the beginning of next year. The problem with this notion is that the ECB has said several times that the PEPP program will end in March 2022, implying that the pace of bond buying will also be slowing in 2022. Therefore, the market expects that the end of the PEPP program will be compensated by another scheme such as the APP by making it more flexible. However, hawks reject this notion strongly, and it could prove challenging to find a compromise this week. Any deferral in the decision concerning a temporary replacement for the PEPP program could be perceived as fading ECB support, causing volatility in sovereigns with a high beta such as the periphery.
The ECB macroeconomic projections will also be in focus, particularly concerning inflation. In September, the central bank forecasted inflation at 2.25, 1,7%, and 1,5% for 2021, 2022, and 2023. It will be important to see if forecasts for 2022 and 2023 will be revised upwards, indicating that inflationary pressure might become more permanent.
From a bond point of view, it’s vital to recognize that covid distortions continue to cap bond yields. Still, more elements are putting upward pressure on them. Inflationary pressures, fading ECB support, and a new German government suggest that the only way for European yields is up. Therefore, if Lagarde sounds slightly less dovish than what the market expects, it might reason to see yields soaring.
Ten-year Bund yields have adjusted 15bps lower since the omicron variant was discovered. Contrary to our earlier analysis, we don’t believe that Bund yields will break above 0% by the end of the year due to the recent Covid restrictions. However, they could rise to test resistance at -0.20%.
The BOE could wait to hike interest rates.
The market has been expecting for a long time a 10bps rate hike from the BOE, but it might be disappointed once again. The most hawkish MPC member, Michael Saunders, said he would need to think about it twice before hiking interest rates, making a rate hike in December less likely. The market is now pushing back on rate hike expectations in the UK amid Covid restrictions. However it is still expecting more than three interest rate hikes next year, the most aggressive tightening pace than other developed countries.
It’s safe to assume that a dovish BOE will force the market to reconsider the central bank’s hiking agenda further, provoking yields to drop, especially in the front part of the yield curve. Yet, the central bank will welcome the move as it will steepen the yield curve.
Economic Calendar
Monday, December the 13th
- Japan: Tankan Large Manufacturing Index (Q4)
- United Kingdom: Financial Stability report
- United states: 3-month and 6-month Bill Auction
Tuesday, December the 14th
- Japan: Industrial production (Oct)
- United Kingdom: Average Earning Including and Excluding Bonus (Oct), Claimant Count (Nov), ILO Unemployment Rate (Nov)
- Switzerland: Producer and Import Prices (Nov)
- Eurozone: Industrial Production (Oct)
- United States: Producer Price Index (Nov), Redbook Index (YoY)
Wednesday, December the 15th
- New Zealand: REINZ House Price Index (Nov), Current Account (Q3)
- Australia: Westpac Consumer Confidence (Dec)
- China: House Price Index (Nov), Industrial Production (Nov), NBS Press Conference, Retail Sales (Nov)
- United Kingdom: Consumer Price Index (Nov), PPI Core Output (Nov), Retail Price Index (Nov)
- France: Consumer Price Index (EU Harmonized) (Nov)
- Spain: Consumer Price Index (Nov)
- Italy: Consumer Price Index (Nov)
- United States: Retail Sales (Nov), Retail Sales Control Group (Nov), Fed’s Interest Rate Decision, Fed’s Monetary Policy Statement, FOMC Economic Projections, FOMC Press Conference
- Canada: BoC Consumer Price Index (Nov), Manufacturing Sales (Oct), BoC’s Governor Marcklem speech
Thursday, December the 16th
- New Zealand: Gross Domestic Product (Q3)
- Australia: Commonwealth Bank Manufacturing, Bank Service and Composite PMI (Nov), RBA’s Governor Lowe speech, Westpac Leading Index (Nov), Employment Change (Nov), Consumer Inflation Expectations (Dec), Unemployment Rate (Nov)
- China: FDI – Foreign Direct Investment (Nov)
- Eurozone: European Council Meeting, Markit PMI Manufacturing, Service and Composite (Dec), Labor cost, ECB Interest Rate Decision and Monetary Policy Decision Statement, ECB Press Conference
- France: Markit PMI Manufacturing, Service and Composite (Dec)
- Germany: Markit PMI Manufacturing, Service and Composite (Dec)
- Switzerland: SNB Interest Rate Decision and Policy Assessment
- United Kingdom: Markit PMI Manufacturing and Service (Dec), Bank of England Minutes, BOE Asset Purchase Facility, BOE Interest Rate Decisions.
- Spain: 3-year, 5-year, and 10-year Bond Auctions
- United States: Building Permits (Nov), Housing Starts Changes (Nov), Initial Jobless Claims, Markit PMI Manufacturing, Service and Composite (Dec), 4-week Bill Auction
Friday, December the 17th
- Japan: BOJ Monetary Policy Statement and Interest rate Decision
- Eurozone: EU Leaders Summit, Consumer Price Index (Nov)
- United Kingdom: GfK Consumer Confidence (Dec), Retail Sales (Nov)
- Germany: Producer Price Index (Nov), IFO Business Climate, Current Assessment and Expectations (Dec), 30-year Bond Auction
- United States: Fed’s Waller speech
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