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 US yield curve will continue to bear-flatten as interest rate hikes expectations accelerate and growth fears increase. We see balance sheet policies as the only factor able to stop this trend while the Federal Reserve stays aggressive. Still, we do not expect the central bank to communicate its intentions before June. In the meantime, credit spreads have become more relevant, with junk bond funds suffering the largest exodus since September 2020. The spread between high-yield and investment-grade bonds is also widening, indicating that sentiment in markets is changing. In Europe, the focus is on the ECB this week, as it still has to clarify its posture towards inflation. Yet, an aggressive Federal Reserve last week and Bank of England this week will force Bund yields into positive territory. We expect the BTPS-Bund spread to tighten this week as investors welcome the news of Mattarella remaining President of Italy for a second mandate. However, soon after, the spread will resume its widening as high-beta BTPS suffer from volatility in bond markets.
There is no escaping the bear-flattening of the yield curve.
Although the Federal Reserve had the unique opportunity to take control of the market narrative last week, it decided not to do so. The central bank catches up with markets as sustained inflation becomes a more significant problem. In our view, this posture will cause the Fed to become more aggressive throughout the year, creating the perfect environment for a policy mistake that might derail the economic recovery.The key points that emerged from last week’s FOMC meeting can be summarized as follow:
- “The Committee views changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy."[1]
- The Fed is getting ready to hike rates at its March 16th meeting and reduce its balance sheet soon after.
- Tapering of bond purchases will continue as announced in December, leading to zero purchases by March.
The first point is pivotal, and it can be linked to last week's sharp flattening of the yield curve. By using interest rate hikes as the primary tool of tightening the economy, the front part of the yield curve will shift higher. In contrast, the long part of the yield curve will remain compressed amid fears of an economic slowdown. We see this as one of the main threats for markets in 2022 because investors might need to price for even faster rate hikes than what they have done since the beginning of the year. After all, Powell said there is room to raise rates without hurting the labor market. Investors caught the message, and while before the FOMC meeting, markets priced four rate hikes this year, we are now looking at five. Hence, 2-year yields hit their highest level since February 2020 and the 2s10s spread tightened by 20bps to 60bps, the lowest since October 2020.
Although the runoff of the Fed's balance sheet seems to take a secondary role in monetary policies, we continue to believe it will cover a critical role in the future. At the press conference, Powell mentioned that the Fed might be more aggressive in reducing its balance sheet than in previous instances. It would apply enough upward pressure to long-term yields if that were true, preventing the long part of the yield curve from collapsing due to growth concerns. The market is currently underestimating balance sheet policies. If its runoff is more aggressive than expected, it could force markets to pull back on rate hikes expectations. Indeed, if bold enough, a balance sheet reduction could help the central bank avoid proceeding with as many hikes as the market is currently pricing. However, the fact that the Fed did not end tapering last week makes the market doubt the Fed’s intentions and contributes to a steady flattening of the yield curve.
As the yield curve bear-flattens, signs of an inversion, thus a policy mistake, increase. So far, the spread between 7-year and 5-year yields is on the verge of inverting, as it shrunk down to 2bps last week.
This week the non-farm payrolls will be in focus. Still, they will do little to persuade the Federal Reserve against tightening the economy as the fight against inflation is now driving markets’ narrative.
The only thing that could deter the central bank from its aggressive agenda is the malfunctioning of debt markets. So far, we are not witnessing significant hiccups. Yet, January's exodus of investors from lower-rated corporates has been substantial. The iShares iBoxx High Yield Corporate Bond ETF (HYG) suffered the largest drop of fund flows since September 2020. The spread between high-yield and investment-grade bonds has widened by 54 basis points since the beginning of the year. It shows that risk sentiment is quickly changing despite junk bond spread remaining tighter than pre-pandemic levels. Therefore, lower-rated corporates are soon going to be facing a challenging financing environment. At that point, the Federal Reserve will need to decide between fighting inflation and financing stability.
The market wants to know how worried the ECB is about inflation.
The ECB will most likely not deliver any new policy announcement on Thursday. However, the focus of investors will be on the press conference, where the market will try to understand how less accommodative the ECB will be going forward. It’s natural that as the pandemic ends and the economy recovers, crisis-fighting tools will also be discontinued. However, how fast can that happen?
The ECB is facing the problem that with an aggressive Federal Reserve across the Atlantic, the cost of funding is also meant to rise in the euro area. Indeed, the correlation between Bunds and US Treasuries is close to one, meaning that if yields rise in the US, they will follow in Europe, too. On top of that, the discontinuation of the PEPP program in March will add upward pressure on sovereign yields, contributing to an indirect tightening of financing conditions. That’s why, even if members begin to be concerned about inflation, the ECB might decide to take a wait-and-see approach before communication tilts on the hawkish side.
Regardless, it is just a matter of time before we see 10-year Bund yields trading consistently above 0%, and this week’s ECB monetary policy meeting might help with that.
The Italian political crisis is over, for now.
Mattarella has accepted to run a second mandate as President of the Republic, removing the political risk BTPS have recently been suffering from. Although the BTPS-Bund spread has been tightening on the news, it is hard to think that we will see it contracting further this year. Indeed, Italian sovereigns carry high beta. Therefore, in a context of high volatility in bond markets, they will be more vulnerable than their peers.
That’s why we remain constructive on our view that the BTPS-Bund spread will widen to 160bps by the end of the year. The spread will resume tightening when central banks will slow down their hiking plans, compressed further by the commitment of the new German government to create a better integrated Europe.
A hawkish Bank of England will lift Gilt yields across the curve.
After hiking rates in December, the Bank of England is expected to hike by another 25bps at its upcoming policy meeting on Thursday. However, the focus for investors will be on Bailey's speech and his expectations on the path of interest rate hikes for this year. Another rate hike could trigger QT as soon as March. Indeed, the BoE’s primary policy rate is the same rate that the central bank pays commercial banks for the reserves created through QE. In a nutshell, QE becomes more and more expensive to carry on as the benchmark interest rate increases. A double tightening could see Gilt yields rising fast across the whole yield curve as interest rate hikes will lift the front part of the yield curve, but a balance sheet reduction will put upward pressure on long-term yields. Economic calendar
Monday, January the 31st
- Japan: Industrial Production (Dec), Large Retailer Sales (Dec), Retail Trade (Dec)
- Spain: Consumer Price Index (Jan) prel, HICP (Jan) Prel
- Italy: Gross Domestic Product (Q4) prel
- Eurozone: Gross Domestic Product (Q4) prel
- Germany: Consumer Price Index (Jan) prel, Harmonized Index of Consumer Prices (Jan) prel
- United States: Chicago Purchasing Managers’ Index (Jan), Dallas Fed Manufacturing Business Index (Jan), 3-month and 6-month Bill Auction
Tuesday, February the 1st
- Australia: AiG Performance of Mfg Index (Jan)
- New Zealand: Trade Balance (Dec)
- Japan: Jobs / Applicants Ratio (Dec), Unemployment Rate, 10-year Bond Auction
- Australia: Home Loans (Dec), Retail Sales (Dec), RBA Interest Rate Decision, RBA Rate Statement
- United Kingdom: Nationwide Housing Prices (Jan), Markit Manufacturing PMI (Jan), Consumer Credit (Dec), M4 Money Supply (Dec)
- Germany: Retail Sales (Dec), Markit Manufacturing PMI (Jan), Unemployment Rate (Jan)
- France: Consumer Price Index (Jan), Markit Manufacturing PMI (Jan)
- Spain: Markit Manufacturing PMI (Jan)
- Italy: Markit Manufacturing PMI (Jan)
- Eurozone: ECB Bank Lending Survey, Markit Manufacturing PMI (Jan), Unemployment Rate (Dec)
- Canada: Gross Domestic Product (Nov), Markit Manufacturing PMI (Jan)
- United States: Markit Manufacturing PMI (Jan), ISM Manufacturing Employment Index (Jan), ISM Manufacturing PMI (Jan)
Wednesday, February the 2nd
- New Zealand: Employment Change (Q4), Labour Cost Index (Q4), Participation Rate (Q4), Unemployment Rate (Q4)
- Australia: RBA’s Governor Lowe Speech
- Italy: Consumer Price Index (Jan) Prel
- Eurozone: Consumer Price Index (Jan) Prel
- United States: ADP Employment Change (Jan)
- Canada: Building Permits (Dec), BoC’s Gravelle speech
Thursday, February the 3rd
- Australia: AiG Performance of Construction Index (Dec), Commonwealth Bank Service PMI (Jan), Building Permits (Dec), Trade Balance (Dec), National Australia Bank’s Business Confidence (Q4)
- Spain: Markit Services PMI (Jan)
- Italy: Markit Services PMI (Jan)
- France: Markit Services PMI (Jan), Markit PMI Composite (Jan)
- Germany: Markit Services PMI (Jan), Markit PMI Composite (Jan)
- Eurozone: Markit Services PMI (Jan), Markit PMI Composite (Jan)
- United Kingdom: Markit Services PMI (Jan), Bank of England Minutes, BOE Asset Purchase Facility, BOE Interest Rate Decision, BOE MPC Vote Rate hikes/cuts/unchanged, Monetary Policy Summary, BOE’s Governor Bailey speech
- Eurozone: ECB Deposit Rate Decisions, ECB Interest Rate Decision, ECB Monetary Policy Decision Statement, ECB Press Conference
- United States: Initial Jobless Claims, Unit Labor Costs (Q4) prel, Markit Services PMI (Jan), Markit PMI Composite (Jan), Factory Orders (Dec), ISM Services Employment Index (Jan), ISMA Services New Orders Index (Jan), ISM Services PMI (Jan), ISM Services Prices Paid (Jan), 4-wee and 8-week Bill Auction
Friday, February the 4th
- New Zealand: Building Permits (Dec), RBA Monetary Policy Statement
- Germany: Factory Orders (Dec)
- France: Industrial Output (Dec), Nonfarm Payrolls (Q4) prel
- United Kingdom: Markit Construction PMI (Jan)
- Eurozone: Retail Sales (Dec)
- United States: Nonfarm Payrolls (Jan), Average Hourly Earnings (Jan), Average Weekly Hours, Labor Force Participation Rate, Unemployment Rate, U6 Underemployment Rate (Jan)
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