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.

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.

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