We believe that US interest rates will reach the 3.25%-3.50% range by the end of 2022 as the Federal Reserve tries to orchestrate a major slowdown in the economy, or even a downturn. anticipating a recession, in order to moderate inflation. The ECB will probably adopt a less aggressive strategy. On the various bond segments, the “peripheral” bonds of the euro zone could underperform. As for Asian bond spreads, they could normalize.
- Sovereign bonds suffered their biggest correction in years
- The US Treasury Yield Curve Flattened Quickly
- Inflation breakevens widened in the US on sustained demand for inflation-protecting securities
- Yield curves for sovereign securities have steepened in the euro zone
- Spreads on sovereign bonds from “peripheral” countries widened in anticipation of the end of the ECB’s asset purchases.
Watch out, the Fed is going to put the brakes on
In the United States, inflation has spread beyond commodities and is now affecting services. Unlike the Federal Reserve, we struggle to see how inflation could get closer to its target if growth barely slows and returns to trend. The increases that will be put in place to return policy rates to neutral seem insufficient to fight inflation, slow growth (which would reduce supply bottlenecks) and ease wage pressures .
In our view, the Fed should take rates into restrictive territory. We therefore expect several 50bp hikes through the rest of 2022. Further hikes are possible in 2023, depending on the persistence of inflation and the resilience of the economy to the consequences of the conflict between the Ukraine and Russia. This potential path for key rates is significantly more aggressive than what we had forecast in our first quarter outlook.
We believe the Fed needs to stage a major economic slowdown to bring wage pressures down to a level consistent with its 2.0% inflation target. Real forward yields (5yrs 5ys ahead) are expected to rise 75bps to 150bps. The Fed will therefore have to press harder on the monetary brake.
Regarding its balance sheet, the Fed will probably accelerate its efforts to move from a portfolio ofopen market to a government securities portfolio. However, it should be borne in mind that restoring the balance sheet to its levels of the beginning of 2020 (pre-pandemic) would take five to six years and that, in the meantime, excess liquidity could continue to weigh on risk premia, including Treasury bill term premia.
Another question: how will the US Treasury proceed to increase its financing, which should have been provided by the Fed? We think he will probably focus his issues on short-term securities, which are very popular with money market funds. In addition, demand for long-term treasury bills from pension funds was sustained due to the improvement in their solvency.
As for the inflation outlook, we believe that the surge in commodity prices may not fully reverse. Lockdowns in Shanghai and other major Chinese ports and cities are also creating new inflationary risks. The surge in energy prices has highlighted the structural inflationary pressures induced by the transition to sustainable energies and the phenomenon of de-globalization. These trends justify a premium on break-even inflation.
The ECB is showing increased caution
The Eurozone could also face rising energy and commodity prices and higher inflation. The inflation rate could accelerate to 7% to 8%, before falling back to a level closer to the ECB’s 2% target in late 2023 or early 2024, when the impact of rapidly rising energy prices will dissipate.
Labor market tightness and high inflation should support wage growth this year. However, downside risks cannot be ruled out. Companies are having to deal with rising production prices and pressure on their margins, while growth trends could reduce the bargaining power of unions. The Russia/Ukraine conflict could slow down growth and the labor market.
Faced with permanently higher inflation, the ECB chose to normalize its policy. However, a sense of urgency could soon materialize and force the ECB to give more concrete indications on its timetable for raising interest rates.
We are quite in agreement with the forecast that the ECB will start its tightening cycle in the second half of 2022. However, given the deterioration in economic, business and household sentiment, the ECB will probably be reluctant to intervene, especially in relation to the tightening orchestrated by the Fed to curb budgetary measures and increasingly intense and endogenous inflationary pressures.
In the short term, the bonds of the “peripheral” countries of the euro zone could underperform. Italy and Spain have reduced fiscal leverage to deal with the economic consequences of the Ukrainian crisis, while the end of the ECB’s asset purchase programs will put “peripheral” bonds under pressure. In the longer term, European budgetary solidarity and the ECB’s desire to fight against the risk of North-South fragmentation should limit the widening of spreads.
In relative terms, we believe UK Gilts will outperform US Treasuries due to the diverging growth outlook between the UK and US. Squeezing real incomes and tightening monetary policy will likely slow the UK economy, reduce inflation expectations and limit the need for aggressive rate hikes.
Corporate Bonds – We are Positive on European High Yield
corporate bonds investment-grade evolved as in previous rate hike cycles: they underperformed in the months preceding the first hike but also immediately after (see Chart 1). This time around, its underperformance has been more pronounced due to high valuations, already low spreads and the conflict in Ukraine which is raising concerns about growth prospects.