BlueBay AM: A bond market hangover

March 25, 2022

Yields peaked at the end of March 2021 – could we see a repeat of this pattern in 2022?

Hawkish comments from the Federal Reserve (Fed) saw Treasury yields continuing to press higher over the past week. It appears that FOMC members are concluding that one or more 50bp hikes may be needed to restrain inflation at a time when financial conditions remain accommodative and policy rates are a long way below neutral. 

We have argued for some time that the initial 25bp moves may do little to slow growth or inflation in the coming year, with real rates remaining deep in negative territory. However, we have also thought that with the Fed loving to shrink its balance sheet via quantitative tightening, so it would be less inclined to become overly aggressive on rates, especially against a backdrop of ongoing geopolitical uncertainty.  

Indeed, we see scope for GDP to contract in Q2 as prices jump and this impacts consumption. Yet with wages moving higher in a tight labour market and inflation expectations starting to de-anchor, a setback to growth may not be long lasting. 

Moreover, we are now in a world where central bankers will have little choice but to respond to inflationary developments. Twelve months ago, we wrote how the Fed and others had got their analysis completely wrong in their dismissal of inflationary pressures in the wake of a Covid recovery as solely transitory in nature. This language appears to be long forgotten and it is broadly accepted that medium-term economic prosperity will depend on preserving some measure of price stability.  

Consequently, it seems accepted that interest rates will ultimately need to become restrictive in this cycle and cause growth to slow. In this context, the playbook of the 04-06 gradual tightening cycle may be starting to give way to a replay of the 1994 Fed hikes. 

At this time, the Fed was reacting more to strong growth rather than surging inflation, and although aggressive hiking did not end in a recession, there was a marked slowdown in growth that saw the Fed needing to ease less than 12 months thereafter.

A more aggressive Fed creates a more challenging backdrop for risk assets. A gradual hiking cycle appeared to constitute little risk to ongoing expansion, but a more unpredictable path for rates will inevitably raise recession risks. This uncertainty may also demand a more sustained increase in risk premia – a factor that may also be supported by ongoing geopolitical risks, which seem unlikely to disappear any time soon.

In contrast, the Bank of England (BoE) has wanted to sound less hawkish than its peers in recent weeks. This has led UK rates to outperform, but we think that this may be short lived. The BoE has been consistently behind the curve in its assessment of building inflation pressures. 

Thanks to Brexit shortages coupled with a more rapid normalisation post-Covid than many other countries, we see scope for UK inflation to further overshoot and would note that, historically speaking, the UK has had more of a tendency for inflation expectations to de-anchor than elsewhere. 

We now see UK RPI moving into double digits in the coming months. Consequently, the BoE will have little option to raising rates further at coming meetings, even if that means impacting growth and putting pressure on inflated house prices.

In the eurozone, we see inflation expectations as more contained, and this should limit the need for the ECB to hike after it ends its Asset Purchase Programme. More than 150bp of hikes are discounted in the next 18 months; this appears somewhat aggressive in our opinion. Consequently, we continue to favour eurozone fixed income relative to UK Gilts and Treasuries. 

Meanwhile, we also look for JGB yields to push higher in response to moves in global markets. There seems little room for JGBs to rally and therefore a short stance is warranted, in our view, given the asymmetric return profile.

Credit spreads have remained relatively volatile on day-to-day moves tracking headlines from Russia/Ukraine, as well as reacting to moves in government bond yields. Yet after widening materially in February and early March, there has been a broad-based recovery from the lows, tracking sentiment in equity markets. 

We continue to see more opportunities in credit based on a relative value long/short approach, rather than expressing an outright view on market direction. However, absolute yields on credit asset classes are clearly much more appealing on a medium-term view than was the case earlier in the year, given how yields have risen as spreads have widened, even as government yields have pushed upwards

In emerging markets, a currency devaluation in Egypt has put a negative spotlight on North Africa. Rising food prices remain an issue in a lot of the developing world and provide a further reminder that many countries are facing intractable issues even as US rates rise, putting pressure on funding.

Elsewhere, FX continues to see relatively low volatility from an asset class perspective. The yen has underperformed as rate spreads widened, while the Australian dollar has been a beneficiary along with other commodity currencies.

Looking ahead

Although we can see how yields may rise further in coming days, based on our medium-term views, in the short term it is possible that rates have sold off as much as they need to. Although the next round of CPI reports will act as a trigger to concerns, slower growth numbers may weigh on sentiment. 

Meanwhile, we would note that yields peaked in 2021 at the end of March and we wonder whether there may be a repeat of this pattern in 2022. Moreover, a world where the Fed may be moving in increments of 50bp is a more unpredictable one. Financial markets have become addicted to policy support in recent years and could be vulnerable if retail faith in buying stocks is challenged in weeks to come.