How the fight against inflation is shifting developed-world bond markets

As the hawkish U-turn by central banks sends shockwaves through the global financial system, how is the developed-world bond market outlook changing? This report is the second part of our latest quarterly assessment of global fixed-income markets, Alphorum. In our previous report in this series, we explored what fixed-income scenarios could result from the current market shock, and how can investors navigate the stagflationary impulse coursing through markets. In the coming days, we will focus on insights into the dynamics driving corporate credit, sustainable fixed income and systematic research. 

Fundamentals and macro

Having insisted for months that inflation was ‘transitory’, the Federal Reserve’s (Fed’s) change of tack in November 2021 can now be seen as pivotal, signalling an abrupt U-turn which has left the Treasury market unanchored without adequate forward guidance. In retrospect, Chair Powell’s acknowledgement that it was time to retire the term heralded a major hawkish shift. This set the tone for the Fed, the Bank of England (BoE) and the European Central Bank (ECB) to announce an acceleration of the removal of accommodative monetary policy in December. Since then, intensifying price pressures have confirmed the urgency for central banks to focus on their anti-inflationary mandate.

The spike in energy and commodity prices triggered by the war in Ukraine simply added fuel to fire. With supply-side constraints lingering in the wake of the pandemic, central banks have limited room to manage the growth implications of this exogenous shock.

At its March meeting, the Fed increased its hawkish stance, projecting the Fed Funds Rate to hit 1.75% by the end of the year — up from below 1% in its December forecast. Meanwhile, the BoE raised its policy rate by 0.25% for a third consecutive time in March, despite striking a more cautious note that “further modest tightening…might be” appropriate. In the Eurozone, dependence on Russian energy makes the economic outlook particularly uncertain. But with inflation now expected to exceed 5% in 2022, the ECB also started removing policy accommodation, opening the door for a potential first rate hike by the end of the year. Amid all this hawkishness the one exception was the Bank of Japan, which continued to pursue a dovish approach in stark contrast to other central banks.

Sentiment

Uncertainty around growth and inflation has increased significantly due to the war in Ukraine. Soaring commodity prices have directly impacted near-term inflation while weakening market confidence, with the problem even more marked in Europe where the risk of an interruption in energy supplies from Russia is a particular concern. This elevated degree of uncertainty is evident in record high option premia for protection against large interest-rate moves. As you can see from the chart, the implied at-the-money volatility of one-year/one-year interest-rate options is almost as high as during the global financial crisis. This means that the one-year rate would need to be more than 50bps above the current one-year forward rate at expiry for this method of protection to prove profitable for a buy-and-hold option investor.

In the US, the urgency to act signalled by the Fed’s 25bps rate rise in March – and hints that 50bps hikes may be on the table in upcoming meetings ­– triggered a dramatic flattening of the US Treasury yield curve. Since the start of the year, the five-year yield has more than doubled to 2.60%, closing the quarter slightly above the 10-year yield. We read the inversion of the curve as a reflection of investors’ views that the Federal Funds Rate is expected to be cut shortly after hitting the cyclical high, towards the end of 2023 or in early 2024.

FIG 1. Implied volatility for one-year/one year interest rate options in USD, EUR and GBP

Source: Bloomberg as at March 2022

Technicals

The technical outlook has deteriorated significantly in recent months, with central banks scaling down their asset-purchase programmes and quantitative-tightening approaching fast. At its February meeting, the BoE announced a form of passive tightening, in that it will begin reducing its UK government bond purchases by ceasing to reinvest maturing assets. Meanwhile, the Fed has signalled the likely announcement of balance sheet reduction at its next meeting in May.

Given high debt levels in the Eurozone, the ECB has been more reluctant to tighten. However, despite the continued use of dovish language around ‘normalising’ and ‘flexibility’, it announced additional purchases will now end in Q3 rather than at the end of the year, with targeted longer-term refinancing operations (TLTROs) starting to roll-off from mid-2022 onwards. Reduced central bank support will mean annual net issuance net of quantitative easing will be higher than previously expected, even before any additional deficit spending on defence and energy, which is particularly likely in the Eurozone.

Valuation

Fed funds futures contracts now price in expectations that the Fed will raise the policy rate above 3% by mid-2023 – well above its long-term neutral rate of 2.5%. Meanwhile, for the ECB, investors dramatically repriced the expected policy rate path for the ECB with Euribor futures contracts now anticipating in the region of seven interest-rate hikes by late next year.

Following the very steep increases in interest rates led by the front end of the yield curve, sovereign fixed-income market valuations are much more balanced than at the start of the year. Breakeven inflation expectations are trading at record highs in many segments. With central banks now expected to act decidedly and swiftly, we see room for medium-term inflation expectations to start consolidating. We expect that the major theme for short-term fixed-income markets in the coming quarters will be to gauge how much tightening major central banks will deliver in their efforts to bring inflation back towards their respective targets. For the long end of the curve, one of the key drivers revolves around the robustness of the medium-term growth outlook in the context of tightening financial market conditions.

Outlook

We see a high probability of 50bps hikes by the Fed at its May and June policy meetings as inflation hits multi-year highs and evidence of tight US labour-market conditions continues to grow. In this environment, pressure on real yields in developed-world sovereign bond markets will likely remain on the upside in the coming months, despite the very rapid tightening policy path having already been priced in by investors. However, with uncertainty elevated and questions about both inflation and growth, implied volatility for money-market rates is almost as high as it was in 2009. A key risk is whether energy supply issues can be contained. Central banks need to regain credibility by acting to contain inflation and the consequent threat to financial stability. However, the removal of policy support in the form of asset purchases creates a difficult environment for sovereign bonds. High levels of sovereign debt and leverage mean interest rates cannot rise too sharply, but there is no clear threshold, in our view.

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