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: We continue to see scope for the US yield curve to bear flatten throughout winter. A new wave of coronavirus might even lead to an inversion, as the market will need to reconsider future growth. Yet, we exclude that the Federal Reserve will step away from its hawkish stance given the persistently high inflationary pressures. In Europe, rates remain in check amid covid distortions. However, we expect them to rise as soon as fears concerning the omicron strain ease. The periphery will suffer from the lack of monetary and fiscal support amid an elevated inflationary environment, with BTPS hurting the most. In the meantime, junk bond credit spreads are widening amid a rise of market and rates volatility in a sign that investors are becoming increasingly risk-averse.
The omicron strain will not steer the Federal Reserve’s focus away from inflation.
It feels like a déjà vu: another strain of covid pushes governments to increase travel restrictions sending the market into a panic. On Friday, investors flew to safety, although there is still little information regarding the new omicron strain. Nobody knows whether it is more contagious or deadlier than previous ones. Yet, on a day where many still enjoyed the Thanksgiving break, algos decided to sell now and ask questions later.
Government bond yields dropped dramatically, with 10-year US Treasury yields falling 17bps, below 1.5%, and 10-year German Bund yields plunging below -0.33%, deleting all November's gains as central banks shifted towards more hawkish monetary policies.
Interestingly enough, the yields of those sovereign bonds with a high beta, such as Italy, also dropped on Friday. It is a sign that the market is anticipating central banks to engage in accommodative monetary policies to save the economy once again. However, this time around, that bias might be wrong. Indeed, during the past few weeks, the White House and several FOMC members admitted that the surge in inflation has begun to be worrisome. After being nominated Fed's vice chair, the same Leal Brainard said that her number one priority would be fighting inflation. Another dove, Mary Daly, mentioned that she’s open in accelerating the pace of tapering.
Therefore, although a new wave of covid might lead governments to impose new lockdown measures, dismissing the central bank’s recent hawkish signs is erroneous. Covid is now coming into play in a moment in which inflationary pressures are at record high levels. New lockdown measures might exacerbate even stronger price pressures as they will further obstruct supply chains. Thus, although interest rate hikes expectations pared back on Friday, it's still safe to assume that the Federal Reserve will continue to taper its purchases, opening up for early rate hikes.
Additionally, if the White House decides on a new stimulus package, that would lead to more bond issuance, further lifting the front part of the yield curve. However, long-term rates will be pinned down by slower or even contracting growth expectations. That scenario matches our expectations that the yield curve will continue to flatten and could be even at the risk of inverting in the first half of 2022.
Regardless of how things will develop concerning the omicron variant, the market seems to agree that last week's bond rally was overdone. The yield curve is bear steepening this morning with 10-year yields back above 1.5%. Yet, the spread between 5s30s yields remains the flattest since February last year.
Job numbers will be in focus on Friday and could strengthen the case for faster tapering in December. Tomorrow and Wednesday, Powell will discuss the CARES act relief and the coronavirus stimulus in front of the Senate.
European sovereigns will suffer once covid distortions resolve.
As fears of a more contagious and deadlier covid variant ease today, we see European yields rising slightly this morning. Yet, government bonds remain underpinned by an assumption of a dovish ECB for longer. We believe European bond yields are poised to soar once covid distortions are cleared. Indeed inflationary pressures continue to rise, making it more challenging for the ECB to justify accommodative policies. This morning, producer prices for Italy rose to a record high of 7.1% monthly (20.4% YoY), and tomorrow's Eurozone CPI numbers are expected to rise to 4.5%. Government bonds from the periphery are more vulnerable to the lack of monetary and fiscal support amid an elevated inflationary environment. Therefore, Italian BTPS are back into focus amid a new wave of coronavirus.
A sudden widening of credit spreads signals that sentiment is changing.
Risky assets are suffering from the news of a new wave of coronavirus. It will be interesting to note that while volatility in the stock market spiked the most since January this year, volatility in junk bonds was more contained.
Yet, compared to the analysis we conducted last Wednesday, we are seeing a substantial difference: junk bond credit spreads to March level, showing an increased risk aversion among investors. So far, the spread level remains in line with historical averages. Nevertheless, it is safe to assume that if the volatility in rates continues to remain elevated, we might begin to see a significant widening of credit spreads, leading to a deeper selloff than the one on Friday.
Economic Calendar
Monday, the 29th of November
- Japan: BoJ’s Governor Kuroda Speech
- Eurozone: Business Climate (Nov), Consumer Confidence (Nov), Economic Sentiment Indicator (Nov), Industrial Confidence (Nov), Services Sentiment (Nov)
- Germany: Harmonized Index of Consumer Prices prel (Nov)
- Canada: Current Account (Q3), BoC’s Governor Macklem speech, BoC’s Schembri speech
- United States: Pending Home Sales (Oct), Fed’s Chair Powell speech, Fed’s Bowman speech
Tuesday, the 30th of November
- Australia: RBA’s Debelle speech, Building Permits (Oct)
- Japan: Jobs, applicants Ratio, Unemployment Rate (Oct), Industrial Production Prel (Oct)
- China: NBS Manufacturing PMI (Nov)
- Switzerland: KOF Leading Indicator (Nov)
- Germany: Unemployment Rate (Nov), German Buba President Weidmann speech
- Italy: Gross Domestic Product (Q3), 10-year Bond Auction, 5-year Bond Auction
- Eurozone: Consumer Price Index Prel (Nov)
- Canada: Gross Domestic Product (Sept)
- United States: Housing Price Index (Sept), S&P/Case-Shiller Home Price Indices (Sept), Chicago Purchasing Managers’ Index (Nov), Consumer Confidence (Nov), Powell and Yellen Testify Before House Panel on CARES Act Relief
Wednesday, the 1st of December
- Australia: AiG Performance of Mfg Index (Oct), Gross Domestic Product (Q3)
- New Zealand: Building Permits (Oct)
- China: Caixin Manufacturing PMI (Nov)
- Germany: Retail Sales (Oct), Markit Manufacturing PMI (Nov)
- Eurozone: Non-Monetary Policy ECB Meeting, Markit Manufacturing PMI (Nov)
- Spain: Markit Manufacturing PMI (Nov)
- Italy: Markit Manufacturing PMI (Nov)
- France: Markit Manufacturing PMI (Nov)
- United Kingdom: Markit Manufacturing PMI (Nov)
- United States: ADP Employment Change, Markit Manufacturing PMI (Nov), ISM Manufacturing Employment Index (Nov), Manufacturing New Orders Index (Nov), ISM Manufacturing PMI (Nov), ISM Manufacturing Prices Paid (Nov), Fed's Beige Book, Powell and Yellen Testify Before House Panel on CARES Act Relief
Thursday, the 2nd of December
- Australia: Trade Balance
- Japan: 10-year Bond Auction, Consumer Confidence
- Switzerland: Real Retail Sales (Oct)
- Italy: Unemployment (Oct)
- Spain: 4-year and 10-year Bond Auction
- France: 10-year, 20-year and 25-year Bond Auction
- Eurozone: Unemployment Rate (Oct)
- United States: Initial Jobless Claims
Friday, the 3rd of December
- China: Caixin Services PMI (Nov)
- Spain: Markit Services PMI (Nov)
- Italy: Markit Services PMI (Nov)
- France: Markit Services PMI (Nov), Markit PMI Composite (Nov)
- Germany: Markit Services PMI (Nov), Markit PMI Composite (Nov)
- Eurozone: Markit Services PMI (Nov), Markit PMI Composite (Nov), Retail Sales (Oct)
- United Kingdom: Markit PMI Composite (Nov)
- United States: Average Hourly Earnings, Average Weekly Hours, Labor Force Participation Rate (Nov), Non-farm payrolls (Nov), U6 Underemployment Rate (Nov), Unemployment Rate (Nov), Markit Services PMI (Nov), Markit PMI Composite (Nov), ISM Services PMI (Nov), ISM Services New Orders Index (Nov), ISM Services Employment Index (Nov)
- Canada: Net Change in Employment (Nov), Participation Rate (Nov), Unemployment Rate (Nov)
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