Short-term yields again attractive in the United States

CENTRAL BANKS

Since the end of 2021, the evolution of the positioning of the main central banks in the face of inflationary pressures has led the markets to anticipate significant rate hikes. We believe that these expectations are justified and should materialize. Thus, Fed Funds rates should be close to 2.5% at the end of the year. As for the European Central Bank (ECB), the deposit rate should turn positive again (it has been negative since 2014 and currently stands at -0.50%), even if the context is more uncertain.

RATE CURVE

After several months of flattening due to the Federal Reserve’s desire to tighten monetary and financial conditions, the US yield curve could now steepen. We outline some of the factors that could lead to this outcome below, with bullish and bearish scenarios for bonds.

Bullish scenarios

  • A deterioration in the outlook for the consumer is likely to weigh on growth expectations and limit the number of rate hikes.
  • An easing of supply chain difficulties and/or geopolitical tensions would reduce inflationary pressures, particularly those related to raw materials.

Downside scenarios

  • Expansion of term premiums due to aggressive quantitative tightening.
  • Unanchoring long-term inflation expectations.

In the US Treasuries market, valuations are more attractive (Chart 4). The short end of the curve currently offers attractive carry levels, which can act as a buffer if rates continue to rise, or if the US yield curve steepens in the wake of quantitative tightening. With regard to the euro yield curve, the breakeven points remain very low (around 10 basis points over a one-year horizon), despite the rise in yields observed since the start of the year. They therefore offer no protection, especially as interest rate volatility remains high.


INFLATION

On the inflation front (and its components), the United States and Europe are in fundamentally different situations. The resulting inflation trajectories (observed and anticipated) partly explain our positions on the yield curves of the two regions. As far as the United States is concerned, the consensus considers that the peak is near. In March, the US CPI was particularly strong, up 8.5% y/y, the Atlanta Fed’s sticky-price inflation index (a weighted basket of items whose price is moving relatively slowly) having meanwhile increased by 4.7% YoY. The acceleration in prices could, however, start to subside, as the core CPI (excluding energy and foodstuffs) rose at a slower pace in March (0.3%) than in February (0.5%).

In Europe, the situation is different and inflation (7.4% YoY in March) should stabilize at a high level over the next few months. Compared to the United States, energy represents a larger contribution and could be a source of adjustment in the near future. Obviously, the EU’s energy vulnerability and the current geopolitical situation reduce visibility for the coming months. In this context, a more pronounced energy shock cannot be completely excluded.

Inflation markets are already fully pricing this in. Inflation swaps are above 2% on all maturities and anticipate high inflation in the near term in both regions. The European swap curve, strongly revalued last month, is now inverted. These elements confirm our belief that inflation breakevens have limited upside potential in the United States, while uncertainty dominates in Europe. In the United States, 2-year and 5-year inflation breakevens have even corrected since the end of March. Consequently, nominal rates could remain volatile on both sides of the Atlantic and rise again in the coming weeks.

CREDIT MARKETS

Credit markets are proving very volatile in 2022. This is due to two main reasons. First: the sharp rise in risk-free rates for several months in the United States and more recently in Europe. Second: the geopolitical crisis in Ukraine, which pushed spreads higher. We reiterate our positive view on high beta markets (European high yield and subordinated debt), while remaining cautious on long durations.

Our view is supported by both fundamental and technical evidence. First, yields are at attractive levels, especially in the euro high yield segment, where indices have reached 4% in recent weeks. Second, issuers have returned to robust balance sheets after the COVID-19 crisis. Whether in terms of debt, interest coverage or cash, they are on average solid and could withstand, to some extent, a deterioration in the macroeconomic outlook. In addition, default rates over the last 12 months are between 1% and 2.6%, as are the rates anticipated by analysts and rating agencies. That being said, the default rates implied by the current spreads stand at 5.5%, which is an appropriate risk offset. However, we observe that flows have been negative since the beginning of the year and that the high yield markets have not offered a new issue for eight weeks.

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