Peak hawkishness: a fixed-income response

As central banks intensify their fight against inflation – and seek to restore eroded credibility – how are fixed-income markets responding? In the developed-markets section of the Q3 issue of Alphorum, we consider the likely impact of current policies, the demise of forward guidance and areas of value that have opened up in the sell-off this year.

Fundamentals and macro

Hindsight is of course 20/20, but we can now safely say that the major central banks reacted to market signals unusually late in the cycle before removing policy accommodation. With inflation continuing to surprise to the upside, June saw a significant acceleration in tightening. This was seen most notably in the Federal Reserve (Fed) overdelivering on expectations with a historic 0.75% rate hike (on top of the 0.50% increase earlier in the quarter), while the European Central Bank (ECB) also took the unusual step of flagging a rate hike in July.

We believe this is likely to represent ‘peak hawkishness’ from a policy standpoint, which should be constructive for bonds. However, because central banks held out for so long in the hope inflation would prove transitory, tightening has yet to affect the demand side and growth. Central banks therefore can’t claim victory over inflation yet, as tight financial conditions will need to be maintained to slow down demand and dampen price pressures.

In the US, where relative energy independence is limiting the economic impact of the geopolitical crisis, the Fed faces a fairly traditional inflationary situation. Price pressures are mostly demand-driven, with the labour market still tight and retail sales and excess savings remaining high. Mortgage rates have shot up towards 6%, but in a fixed-rate market the impact will be far from immediate.

In the Eurozone, in contrast, supply-side pressures are the driving force, creating the risk of stagflation. Higher food and energy prices, essentially a tax on consumption, represented more than 50% of the 8.1% year-on-year rise in the Eurozone consumer price index (CPI) in May. Meanwhile, the risk of emergency gas rationing in Germany and Italy could partially shut down industrial production and create a further supply shock. As a result, the ECB faces significant challenges to engineering a soft landing.

Sentiment

In the light of continual inflation and monetary-policy surprises, implied short–term interest-rate volatility remains at record high levels. Forward guidance is becoming something of a moribund concept, with central banks in the US, the Eurozone and Switzerland all seemingly willing to adjust future inflation projections to fit their current actions. As a result, projections are coming under increasing scrutiny from investors, who are beginning to question the credibility of central-bank policy.

An extreme example is in Japan, where the central bank remains extremely reluctant to adjust its monetary-policy stance despite growing inflationary pressures. While Japanese CPI remains muted for now, the producer price index, which measures the change in the rate of inflation from a manufacturing perspective, is up 23.1% year-on-year. Culturally and structurally, the ability to pass on increased costs is more limited than in some regions, but with such a huge increase it is only a matter of time.

The Bank of Japan’s insistence on being the last dove standing is therefore hard to reconcile with reality. Certainly, investors think so – the yen has depreciated 12.5% year-to-date on a trade-weighted basis, while the central bank’s yield-curve control framework has come under outright attack. In June the bank was forced to purchase Japanese Government Bonds (JGBs) at an unprecedented pace to prevent the 10-year JGB yield from exceeding its 0.25% upper target. The JGB yield curve is now heavily distorted, with the 10-year segment oddly kinked as the BoJ has lost control over the surrounding points (see chart below). Given that it already owns 50% of the JGB market, the bank could be forced to cave to investor pressure and abandon its yield-curve control framework entirely. That could make JGB yields particularly attractive and have repercussions further afield.

FIG 1. Through its yield-curve control framework, the Bank of Japan has created massive distortions

Source: Bloomberg, June 30, 2022.

Technicals

From a technical perspective, the overall situation is fairly neutral. In terms of seasonality, summer tends to be positive for government bonds, with yield moves historically tending downwards. Regarding net supply, the Bank of England has been instituting passive quantitative tightening since February, allowing maturing debt to roll off its balance sheet progressively, while the ECB concluded net new purchases under its Pandemic Emergency Purchase Programme at the end of June. In the US, the Fed has now embarked on gradually reducing its massive USD 8.5 trillion balance sheet. However, reduced quantitative easing will be partly offset by the sharp year-on-year fall in the US fiscal deficit, and resulting lower issuance. Overall net supply is therefore still expected to drop by an estimated 30% this year.  

Valuations

Bond valuations have become much fairer, in our view. In fact, the policy-rate expectations currently priced into the market are higher than our own terminal-rate projections. In the Eurozone, the expected policy rate for the end of 2023 shot up to 2.4% in June, from 1.29% at the end of March. Meanwhile, the Federal Open Market Committee revised its median estimate of the main policy rate at the end of 2023 to 3.8%, up from 2.8%. However, market pricing is now relatively closely aligned with higher dot-plot projections.

Peak hawkishness weighed on breakevens, and also pushed up real yields sharply, with selected segments now offering positive real yields for the first time in years. For example, in June the yield on 10-year Treasury Inflation-Protected Securities breached 0.8% for the first time since 2019, enabling USD-based investors to lock in positive real returns for the next decade.

Outlook

The current situation is a marked improvement from the beginning of the year, when sovereign fixed income was so expensive that its ability to offer investors protection was in question. As evidence, in the risk-off moves in early May and late June, US Treasuries demonstrated some ability to rally and provide uncorrelated returns. However, with central banks forced to keep conditions tight to rein in inflation, near-term performance is likely to be limited.

In the Eurozone, the ECB’s newly announced anti-fragmentation tool is intended to inhibit the opening up of spreads between the sovereign bonds of different member countries. This is a complex problem to address, but the Bank sees it as a prerequisite to starting the lift-off process without putting financial stability at risk. Assuming the tool is successful, this should contribute to a consolidation in peripheral risk premia.

Ultimately, for now central banks are squarely focused on tackling high inflation, leaving no room to consider the growth and employment aspects of their mandates. That creates a risk that tight financial conditions will need to be maintained even as growth slows. In the Eurozone in particular, a stagflationary scenario could become the base case – especially if gas shortages trigger rationing, further weakening growth while driving inflation higher.  

Discover more about our fixed income strategies here.

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