Regime shift in developed-market sovereign bonds

We consider the landscape in developed sovereign bond markets in our latest quarterly assessment of global fixed income, Alphorum. In the coming days, other reports on corporate credit, sustainable fixed income, emerging markets and systematic research will follow.

 

Need to know •    Persistent inflationary pressure spurred the Federal Reserve to commit to start removing monetary accommodation. Ongoing upside surprises in inflation are a concern yet action from central banks should help offset these. •    Changing rate expectations and reduced liquidity contributed to a dramatic flattening of the US Treasury yield curve, and US forward breakeven levels remain elevated. •    In the context of solid growth momentum and firm inflation expectations, we see room for a gradual rise in nominal yields, led by a rebound in real yields from record low levels.

 

Fundamentals and macro

The final quarter of 2021 closed a challenging year with the Omicron Covid variant putting investors on alert once more. It seems increasingly likely that Omicron will be confirmed as more transmissible but less virulent than previous variants. If that proves to be the case, we expect governments will be in a position to focus on boosting vaccination programs while largely avoiding additional containment measures that weigh on economic activity. In the absence of major disruption, global economic activity is set to continue to expand strongly going into 2022, albeit at a more moderate pace than in 2021.

On the inflation side, there was further evidence that supply-side bottlenecks are proving more persistent than was expected earlier in the year. Both order backlogs and supply delivery times jumped across regions, while a record number of companies in Europe reported a shortage of materials. In the US, the labour market started to react to tight conditions in specific sectors, with the employment cost index rising at 3.7% year-on-year in the third quarter of 2021. Further upside surprises in the latest Consumer Price Index (CPI) prints led Fed Chair Powell to acknowledge that rising inflation pressures could no longer be described as ‘transitory’.¹ In response, the Federal Open Market Committee (FOMC) announced that tapering will be accelerated to conclude net asset purchases in March 2022. At the same time, the Committee’s median expectations for the end-of-2023 Fed Funds policy rate were raised to 1.6%, from 1% in September 2021.

 

Sentiment

Ongoing inflation pressures prompted investors to pull forward the expected timing and pace of interest rate increases, with the repricing particularly sharp in New Zealand, Australia and Canada. The Reserve Bank of New Zealand raised its policy rate further to 0.75%, while the Reserve Bank of Australia was forced to abruptly abandon its yield curve control policy as the credibility of the framework came under increasing pressure. In the Eurozone, front-end interest rate volatility also picked up and triggered some pushback from policy makers. Still, largely in line with expectations, in December the ECB announced it would taper its asset purchases in 2022. In contrast to the Fed that will halt net purchases in March, the ECB will reduce additional purchases in a more gradual manner over the course of the year.

Despite the repricing of front-end interest rates, long-term interest rates moved lower to extend the dramatic year-to-date flattening of yield curves across developed markets. In the US, the 5-year/30-year US Treasury yield differential fell another 10 bps to close the year at 0.64%. With front-end interest rates now anticipating multiple Fed Fund hikes in 2022 and 2023, the flatness of the yield curve implies investors are unconvinced the Fed will be able to lift the policy rate to the FOMC’s long-term neutral level of 2.5%. 

 

Technicals

Reduced liquidity going into year-end may also have played a role in the flattening move that drove long-term interest rates to historically stretched levels in November. Increasing confidence that the economic repercussions of the Omicron variant will be relatively modest was supportive of a rebound in sovereign bond yield in the final two weeks of the year. Still, when assessing the yield curve against the interest rate dynamics observed in previous run-up lift-off episodes, the current levels of long-term interest rates appear stretched.

 

Valuation

In our Q4 2021 publication we argued that inflation expectations could consolidate as we edged closer to a wider reduction in asset purchases. In the event, an exceptionally high October CPI print sent expectations of persistent high inflation soaring, with breakevens reaching historically rich territory in mid-November. They have since seen some consolidation but remain far higher than a year ago, as you can see from the comparison in the chart below.

 

Figure 1. Comparison of US forward one-year breakeven rates

Source: LOIM, Bloomberg as at December 2021. For illustrative purposes only.

 

Despite stabilising as the rebuff of the transitory thesis triggered a more vigilant stance from central banks globally, breakevens remain quite elevated, with the market continuing to price in a sustained period of higher inflation. Certainly, ongoing upside surprises in inflation are a concern, however, action from central banks should go some way to offsetting this. Rhetoric from policymakers has pivoted to a more hawkish tone, with the Fed and Bank of England already taking action in terms of anti-inflationary monetary policy as 2021 drew to a close. As a result, looking ahead we see some room for consolidation in inflation expectations, supported by annual inflation peaking in Q1 2022.

We also expected real yields to drift higher in the final quarter of 2021. These expectations were confounded. However, we still see a strong case for real yields to start correcting higher going into 2022, as valuations near all-time highs look stretched by most metrics.

 

Outlook

Over the final quarter of 2021, the credibility of the forward guidance being provided by developed market central banks was challenged. This marks a significant regime shift for sovereign bond markets. Following the sharp repricing in short-term rates over the past few months, the richness in developed markets is more pronounced in long maturity bonds. By comparison, front-end bonds look more fairly priced. In the context of solid growth momentum and firm inflation expectations, we see room for a gradual rise in nominal yields, led by a rebound in real yields from record low levels.

On the political front we will closely monitor developments in Italy in particular. If prime minister Mario Draghi is elected as the new president in the upcoming presidential elections, an interim government will likely be formed until the 2023 parliamentary elections. However, the likelihood of early parliamentary elections will increase; this could trigger increased BTP spread volatility, particularly in the context of reduced ECB asset purchases.

À l’usage des investisseurs professionnels uniquement
Le présent document a été publié par Lombard Odier Funds (Europe) S.A., société anonyme (SA) de droit luxembourgeois, ayant son siège social sis 291, route d’Arlon, 1150 Luxembourg, agréée et réglementée par la CSSF en tant que Société de gestion au sens de la directive 2009/65/CE, telle que modifiée, et au sens de la directive 2011/61/UE sur les gestionnaires de fonds d’investissement alternatifs (directive GFIA). La Société de gestion a pour objet la création, la promotion, l’administration, la gestion et la commercialisation d’OPCVM luxembourgeois et étrangers, de fonds d’investissement alternatifs (« FIA ») et d’autres fonds réglementés, d’organismes de placement collectif ou d’autres véhicules d’investissement, ainsi que l’offre de services de gestion de portefeuille et de conseil en investissement.
Lombard Odier Investment Managers (« LOIM ») est un nom commercial.
Ce document est fourni à titre d’information uniquement et ne constitue pas une offre ou une recommandation d’acquérir ou de vendre un titre ou un service quelconque. Il n’est pas destiné à être distribué, publié ou utilisé dans une quelconque juridiction où une telle distribution, publication ou utilisation serait illégale. Ce document ne contient pas de recommandations ou de conseils personnalisés et n’est pas destiné à remplacer un quelconque conseil professionnel sur l’investissement dans des produits financiers. Avant de conclure une transaction, l’investisseur doit examiner avec soin si celle-ci est adaptée à sa situation personnelle et, si besoin, obtenir des conseils professionnels indépendants au sujet des risques, ainsi que des conséquences juridiques, réglementaires, financières, fiscales ou comptables. Ce document est la propriété de LOIM et est adressé à son destinataire pour son usage personnel exclusivement. Il ne peut être reproduit (en totalité ou en partie), transmis, modifié ou utilisé dans un autre but sans l’accord écrit préalable de LOIM. Ce document contient les opinions de LOIM, à la date de publication.
Ni ce document ni aucune copie de ce dernier ne peuvent être envoyés, emmenés ou distribués aux États-Unis, dans l’un de leurs territoires, possessions ou zones soumises à leur juridiction, ni à une personne américaine ou dans l’intérêt d’une telle personne. À cet effet, l’expression « Personne américaine » désigne tout citoyen, ressortissant ou résident des États-Unis d’Amérique, toute association organisée ou existant dans tout État, territoire ou possession des États-Unis d’Amérique, toute société organisée en vertu des lois des États-Unis ou d’un État, d’un territoire ou d’une possession des États-Unis, ou toute succession ou trust soumis dont le revenu est imposable aux États-Unis, qu’en soit l’origine.
Source des chiffres : sauf mention contraire, les chiffres sont fournis par LOIM.
Bien que certaines informations aient été obtenues auprès de sources publiques réputées fiables, sans vérification indépendante, nous ne pouvons garantir leur exactitude ni l’exhaustivité de toutes les informations disponibles auprès de sources publiques.
Les avis et opinions sont exprimés à titre indicatif uniquement et ne constituent pas une recommandation de LOIM pour l’achat, la vente ou la détention de quelque titre que ce soit. Les avis et opinions sont donnés en date de cette présentation et sont susceptibles de changer. Ils ne devraient pas être interprétés comme des conseils en investissement.
Aucune partie de ce document ne saurait être (i) copiée, photocopiée ou reproduite sous quelque forme et par quelque moyen que ce soit, ou (ii) distribuée à toute personne autre qu’un employé, cadre, administrateur ou agent autorisé du destinataire sans l’accord préalable de Lombard Odier Funds (Europe) S.A. Au Luxembourg, ce document est utilisé à des fins marketing et a été approuvé par Lombard Odier Funds (Europe) S.A., qui est autorisée et réglementée par la CSSF.
© 2022 Lombard Odier IM. Tous droits réservés.