We expect official US interest rates to be raised to 3.25%-3.50% by year-end 2022 as the Federal Reserve engineers a major economic slowdown, and most likely a recession, to cool inflation. The ECB will likely be on a less aggressive path. Within fixed income, we see a risk that ‘peripheral’ eurozone bonds will underperform. Elsewhere, Asian spreads look set to normalise.
- Sovereign bonds saw the fastest sell-off in years
- The Treasury yield curve flattened rapidly
- US breakeven rates widened amid demand for inflation protection
- Eurozone sovereign curves steepened
- ‘Peripheral’ sovereign spreads widened on the prospect of an end to ECB asset purchases.
Expect the Fed to step harder on the brakes
In the US, inflation has spread beyond core goods to services. Unlike the Federal Reserve, we find itdifficult to see how inflation will soften towards its target if growth is only slowing towards trend. Increases in policy rates to only just above neutral look insufficient to address inflation, slow growth (thereby alleviating supply bottlenecks) and ease wage pressures.
Our view is that the Fed should take rates into restrictive territory. We expect 50bp hikes for the rest of 2022. Further increases are possible in 2023 depending on the stickiness of inflation and the resilience of the economy to the fallout from the Ukraine/Russia conflict. This is a significantly more aggressive path for policy rates than we had projected in our first quarter outlook.
We believe the Fed needs to engineer a major economic slowdown to bring wage pressures to a level consistent with its 2.0% inflation target. 5-year/5-year forward real yields should rise by 75bp to 150bp. The Fed will need to press harder on the monetary brake.
As to the Fed’s balance sheet, while efforts to revert its open market portfolio to an all-Treasury portfolio might be accelerated, it is worth bearing in mind that returning the balance sheet to early 2020 (pre-pandemic) levels would take five to six years, and in the meantime excess liquidity could continue to weigh on risk premia, including Treasury term premia.
On the question of how the US Treasury chooses to raise the financing that would otherwise have come from the Fed, our view is that it is likely to rotate its debt issuance towards bills – which are in demand from money market funds. In addition, demand for longer-dated Treasuries from pension plans has been strong as plan solvency levels have improved.
On the inflation outlook, we believe the surge in commodity prices may not be entirely reversed. New inflation risks are emanating from lockdowns in Shanghai and other major Chinese ports and cities. The surge in energy prices has highlighted the structural inflationary pressures from the transition to sustainable energy and the reversal of globalisation. That warrants a premium in breakevens rates.
The ECB treads more cautiously
In the eurozone, too, the risk of higher energy and commodity prices, and higher inflation, is skewed to the upside. Inflation could accelerate to 7%-8% before falling back to closer to the central bank’s 2% target in late 2023 or early 2024 as the effects of the rapid rise in energy prices fade.
Looking ahead, a tight labour market and high inflation will likely support wage growth this year. However, there are downside risks. Companies need to cope with rising input prices and margin pressures, and growth headwinds may dampen unions’ bargaining power. The Russia/Ukraine conflict could hit growth and the labour market.
Faced with higher-for-longer inflation, the ECB has prioritised policy normalisation. Soon, however, a sense of urgency might translate into more concrete guidance on when interest rates will lift off.
We see expectations of the ECB starting its tightening cycling in the second half of 2022 as fair. However, with data pointing to a deterioration in economic, business and consumer sentiment, the ECB is likely to be careful not to rush, especially compared to the Fed’s tightening path in the face of US fiscal tailwinds and more intense and endogenous inflationary pressures.
In the near term, ‘peripheral’ eurozone spreads could underperform. Italy and Spain have less fiscal space to tackle the economic fallout from the Ukraine crisis and the end of the ECB’s asset purchase programmes will leave ‘peripheral’ bonds under pressure. Longer term, fiscal solidarity in the EU and the ECB’s willingness to fight North-South fragmentation risk should help contain spreads.
On a relative basis, we expect UK Gilts to outperform US Treasuries given the divergence in the growth outlook between the UK and US. The real income squeeze and central bank tightening will likely slow the UK economy, weigh on inflation expectations, and reduce the need for aggressive rate rises.
Corporate bonds – Constructive on European high-yield
The performance of investment-grade corporate bonds has echoed that in previous rate rising cycles, underperforming in the months leading up to the first hike and continuing to underperform immediately after (see Exhibit 1). This time, the underperformance has been larger due to high valuations, low spreads and the Ukraine conflict raising concerns about the outlook for growth.
Among corporate bonds, with valuations closer to long-run averages, we see scope for outperformance, but since this will come mainly from the higher coupon, we are neutral within credit. We nonetheless expect credit to outperform government bonds from here.
In European high-yield, we believe valuations are pricing in some credit stress and there are questions about the ability of issuers to refinance debt. However, we do not expect a recession and have become more constructive. Fundamentals are supportive, corporate liquidity is ample, and we see the default rate staying low for the next 12-24 months.
We are more cautious on US high-yield. We are wary of lower rated bonds given the potential for interest coverage degradation. Nonetheless, metrics have remained solid and earnings reports have been encouraging as companies are beating (albeit lowered) earnings growth expectations.
Emerging markets – Asia credit and local currency debt
Among emerging market bonds, we are heartened by the continued support from Chinese policymakers, which should help embattled property developers as well as Chinese government bonds. Overall, we remain convinced there are attractive opportunities within EM debt.
On the hard currency front, given (the potential for) higher US yields, we have a short duration bias.
On credit, we expect spreads in Asia to normalise. Outsized returns are likely to be driven by Asian high-yield given its attractive valuations and the potential for significant spread compression. We are also looking at idiosyncratic opportunities among sovereigns and corporates.
Within local currency debt, we are defensive on low-yielding issuers where inflation pressures are building and where many central banks have already raised rates. We think there could still be selected opportunities to add to portfolio returns. Looking ahead, we expect to see a rally in local currency bonds on the back of relatively high real rates.
These are highlights from our quarterly fixed income outlook. Download the pdf.