Fixed income market the week ahead

Junk remains resilient to the rise in US Treasury yields, but not for long

Welcome to 2022, a year that will prove challenging due to central banks’ tightening agendas.

We have barely started the year, yet US Treasuries already dropped 1.6% last week, the biggest weekly fall since February 2021 and the second-largest since March 2020. The US yield curve bear-steepened slightly with 2-year yields rising nearly 20bps in a week and 10-year yields soaring by 25bps. Ten-year yields broke and sustained above their strong resistance of 1.75%, which was tested a few times in spring 2021. It's critical to note that an acceleration in real yields has driven the sudden rise in yields. Indeed, as the Federal Reserve becomes more aggressive, breakeven rates decelerate. At the same time, nominal yields soar, provoking a faster rise in TIPS yields. It is terrible news for risky assets, which continue to be underpinned by negative real yields but are facing the prospect of more stringent financing conditions. 

With 10-year TIPS trading at -0.74%, weaker companies are still not showing signs of distress, and duration exposed assets are taking all the heat. Indeed, while the year-to-date total return of high yield corporate bonds is down 1%, high-grade corporates, which are more exposed to duration risk, plunged 2%. It's safe to expect this trend to continue throughout the year and risky assets to become more sensitive to rising real rates as they break above -0.5%.

Last week’s move contrasts with what we had witnessed at the end of November when yields dropped despite the Fed becoming more hawkish. Not much has changed since then. Yet, the latest FOMC minutes might have proved to investors that the central bank is becoming much more hawkish than expected. The Fed is considering reducing its balance sheet this year with tapering and interest rate hikes to tighten the economy, putting longer maturities at risk.

The message is clear: the central bank is behind the curve, and it needs to be more aggressive. A slowdown in growth might not be enough to tilt the Fed from its tightening path. Last Friday's non-farm payrolls showed intensifying pay pressure to confirm such fears, with average hourly earnings rising by 0.6% in December. Employers have difficulties finding workers, and they have to pay up to get them from competitors. Higher salaries are sticky and contribute to long-term inflation. At the same time, supply-chain bottlenecks are unlikely to resolve until 2023. Therefore, even if inflation moderates this year, it’s safe to assume it will remain sustained.

Will US Treasury yields continue to rise?

It's safe to assume that US Treasury yields will continue to rise across the curve, but not at the pace we have seen in the past week. Sustained inflation and aggressive monetary policies will continue to put upward pressure on yields across maturities, especially in the short end. However, when looking at long-term yields, it's key to acknowledge that the more aggressive the Fed becomes, the slower the economic growth. To compress long-term yields further is also the demand for US Treasuries, which should increase as yields get higher. Foreign investors will be compelled to buy US Treasuries now that EUR-hedged 10-year yields offer 0.99%, the most in five years. Not only but, it could be the first time since January 2020 in which a 10-year auction prices above 1.8%.