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 it's all about central banks' monetary policies and how they are planning to pull stimulus away from the economy. US Treasuries are not pricing for a September taper announcement. Therefore, a tapering surprise could provoke 10-year yields on the way towards 1.5%. In a moderately dovish or hawkish FOMC meeting without a tapering announcement, we expect 10-year yields rangebound between 1.26% and 1.40%. Corporate spreads will be under pressure as Evergrande is not expected to pay interests due on Thursday, leading the company towards default. Yet, we expect the natural gas story emerging from the UK to be more relevant to European credit spreads than Evergrande. Indeed, it looks that the old continent is heading towards winter with possible energy shortages where businesses might need to shut again.
Dear readers, it will be a crucial week for the bond market with meetings scheduled for the Federal Reserve, Bank of Japan, Bank of England, Norges Bank and the Riksbank. The common topic will be whether the central banks' respective economies are ready for less accommodative monetary policies. Among these, Norges Bank looks prepared for an interest rate hike, making it the first developed country's central bank to liftoff rates. It would be a powerful signal that the era of low-interest rates in the G10 is coming to an end, although the bond market stubbornly denies it.
Wednesday: Federal Reserve meeting
Buckle your belts because everything is possible. Consensus is expecting a November tapering announcement as August's Nonfarm Payrolls and core inflation readings missed expectations. Anticipating a tapering delay is a safe assumption. It bodes well with Powell's message at Jackson Hole that there is still much ground to cover to maximize employment. It also resonates with US treasury yields which since the beginning of July trade below 1.5%.
However, we feel we cannot exclude a hawkish surprise from this week's FOMC meeting. Indeed, last Friday's University of Michigan survey showed that respondents expect higher inflation in the upcoming months, about 4.7% versus 4.6% from the previous survey. Additionally, respondents anticipate inflation to remain around 2.9% from 5 to 10 years, making the transitory narrative of the Federal Reserve less and less convincing. We believe that it's safer for the Federal Reserve to begin tapering earlier rather than later. Indeed, the later a tapering begins, the more aggressive tapering will need to be in light of sustained inflation numbers. While some of the transitory inflationary pressures (base effects, used cars, gasoline prices, etc...) have already started to wane, other factors such as tourism, natural gas and wages keep contributing to high inflation numbers. Therefore, the market's assumption that there will be only one interest rate hike in 2022 looks way too benign.
To strengthen this point, despite rates have dropped in summer, 10-year US Treasury yields have slowly been rising since July until today, showing that rates' uptrend remains intact. We identify 1.26% and 1.40% as strong support and resistance levels for this week, depending on what happens at Wednesday's FOMC meeting. In the case of an early tapering surprise, we can expect 10-year yields to break above 1.40% on the way to 1.50%. However, it's more likely that a moderately hawkish or dovish message will see yields trading within the range mentioned above.
US debt ceiling
As the Federal Reserve debates on when to pull stimulus from the economy, another topic should be on investors' radar: debt ceiling talks. Yellen recently renewed calls to raise the debt limit to avoid a default of the US Treasury as soon as next month. The debt ceiling is critical because the later a decision to extend it arrives, the more Bills the Treasury will need to issue in a short timeframe resulting in a quantitative tightening. We exclude the possibility that the US Treasury will default. Still, we are monitoring discussion keeping in mind that the later a decision is reached, the bigger the chance for higher volatility. Although demand in the money market remains strong, with the RRP facility hitting new record highs almost weekly, if the US Treasury needs to issue $500bn of securities in a very short timeframe, it will catch the market by surprise. Volatility could even rise further if the Fed begins to taper in the meanwhile.
Thursday: Bank of England
Discussions regarding pulling support from the economy are heating up. Last week’s inflation numbers showed that the CPI reached a ten year high of 3.2%, and central bankers expect it to rise further to 4% during the last part of the year or the beginning of 2022. In the meantime, the job market is recovering quickly, although retail sales continue to disappoint. During the last meeting, the BOE gave some instructions regarding a possible wind-down of its balance sheet. The central bank will start reducing its bond portfolio by not investing proceeds when rates reach 0.5%. It will also engage in actively selling off bonds only when rates hit 1%. Although such targets make the winding down of the balance sheet probable in a couple of years, a tapering announcement might be approaching. During the last meeting, most of the MPC voted in favor of decreasing bond purchases, with Saunders being the only one opposing it.
Credit spreads will be vulnerable to Evergrande and natural gas story
This week will also be a crucial week for credit spreads. Evergrande is not expected to pay interest on existing debt on Thursday, resulting in the second-largest Chinese property developer's default. Although we do not expect contagion outside the Chinese market, it's impossible not to recognize that such a default will undermine China's economic activity, weighing on the world's economy. Consequently, we might see a flight to safety surrounding the Evergrande story, not only in China but also abroad.
Yet, we expect the natural gas story to be a much more significant driver of credit spreads in Europe in the upcoming months than the Evergrande story. In the UK, we are seeing the sixth-largest energy provider, Bulb, in search of a bailout. At the same time, four other energy companies are at risk of default. It's just the beginning of a cold winter where gas shortages are likely, and businesses could be forced to shut. It can have serious implications for the economy and the political sphere as it would add to the pandemic shock.
Economic calendar
Monday, the 20th of September
- Germany: Producer Price Index
- Spain: Balance of Trade
- United States: NAHB Housing Market Index, 3-months and 6-months Bill Auction, UN General Assembly
Tuesday, the 21st of September
- Australia: RBA Meeting Minutes
- United Kingdom: Public Sector Net Borrowing, CBO Industrial Trends Orders
- United States: Current Account, Housing Starts, Building Permits, Housing Starts, Building Permits, Redbook
Wednesday, the 22nd of September
- Australia: Westpac Leading Index
- Japan: BoJ Interest Rate Decision
- Netherlands: Consumer Confidence
- Eurozone: ECB Non-Monetary Policy Meeting, Consumer Confidence
- Italy: Industrial Sales
- United States: MBA Mortgage Applications, 2-year Floater Auction, FOMC Economic Projections, Fed Interest Rate Decision, Fed Press Conference
Thursday, the 23rd of September
- Australia: Markit manufacturing PMI, Markit Services PMI
- Japan: Foreign Bond Investment
- Netherlands: GDP Growth Rate
- France: Business Confidence, Markit Composite, Manufacturing and Services PMI
- Spain: GDP Growth Rate
- Germany: Markit Composite, Manufacturing and Services PMI
- Eurozone: ECB General Council Meeting, Markit Composite, Manufacturing and Services PMI
- United Kingdom: Markit/CIPS Composite, Manufacturing and Services PMI, BOE Interest Rate Decisions, Quantitative Easing, MPC Meeting Minutes
- Canada: Retail Sales
- United States: Chicago Fed National Activity Index, Continuing Jobless Claims, Initial Jobless Claims, Markit Manufacturing PMI, 4-week and 8-week Auction, 10-year TIPS Auction
Friday, the 24th of September
- New Zealand: Balance of Trade
- United Kingdom: GfK Consumer Confidence, Inflation Rate, BoE Tenreyro Speech
- Germany: Ifo Business Climate
- Italy: Business Confidence
- United States: New Home Sales
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