BlueBay AM: An end to 0% rates forever?

18 maart 2022

By Mark Dowding, CIO, BlueBay Asset Management

With inflation trending higher, a return to ‘ZIRP’ seems unlikely as interest rates journey back to neutral.

Hopes that the war in Ukraine could be heading towards a stalemate, which begets a negotiated settlement, provided a lift to risk sentiment during the past week. Meanwhile, market attention switched back to data and policy, with the Federal Reserve (Fed) raising rates by 25bp and indicating an expectation that further hikes and quantitative tightening would follow. 

Notwithstanding Russia risks, we believe the US growth outlook remains relatively robust. The US economy is self-sufficient in energy and many aspects of production, meaning that it is relatively insulated from the recent geopolitical turbulence. The FOMC revised growth down for 2022 while pushing inflation projections higher – yet it would seem that a recession in the next 12-18 months remains very unlikely. We have thought that the Fed could raise rates at every upcoming policy meeting, mirroring the tightening cycle seen in 2004-6. 

Ultimately, we see rates needing to rise beyond the ‘neutral’ point (which the Fed estimates to be at around 2.5%), as we think that inflation will be more persistent than many currently project. However, this is likely to be a gradual trajectory, and with nominal interest rates remaining below CPI, it appears that real rates are set to remain in negative territory for an extended period, implying a relatively accommodative policy stance that should not depress growth prospects by too much.

Consequently, we believe that the medium-term trajectory will be towards higher yields. But in the short term, we feel that rates may have sold off by enough for the time being. 

A total of seven Fed hikes are now priced in for 2022. Against an uncertain macro backdrop, it would be surprising to us for markets to price in a much more aggressive trajectory in the near term, especially with the yield curve starting to invert. Higher inflation prints mean that there is a risk that the Fed hikes by a 50bp increment at an upcoming meeting. 

 However, we think that the FOMC would rather accelerate balance-sheet reduction to avoid a more negatively sloped yield curve, which would raise recession fears that would feed back into the growth outlook. Therefore, we have realised gains on short US rate trades for the time being, even though we maintain a short bias and would look to sell US rates into a rally.

We also believe that the sell-off in euro yields has gone as far as is needed for now. A plunge in the ZEW economic sentiment survey this week served as a reminder that the eurozone economy will likely experience a materially more negative growth shock on the back of the war than is seen across the Atlantic.

In this context, it was interesting to see the FOMC trim 1.2% from its 2022 growth projection. From that point of view, a downward revision to euro area prospects by 2% appears warranted. However, we still see the economy growing by close to 2% in total, allowing for fiscal stimulus. 

To date, we have been disappointed that European fiscal policy initiatives are taking time to coalesce. However, we see plans to spend on defence, energy security and refugees pointing to an outcome where a GDP contraction remains unlikely.

Across the Channel, the BoE was somewhat more dovish than had been projected this week. The MPC hiked rates by 25bp to 0.75%, but without any of the Committee members arguing for a 50bp increase. It appears that the BoE is more concerned about downside risks to growth than other central banks in the wake of a cost-of-living squeeze. However, we see clear signs of inflation expectations de-anchoring in the UK, as well as evidence of wage growth due to a tight labour market. 

Consequently, we think the BoE will need to keep hiking as we move through 2022, raising base rates to 2% by the end of the year. In this context, we remain materially more bearish with respect to Gilt yields than German Bunds.

This macro backdrop suggests that investors are more than fairly compensated for default risks in areas such as investment-grade credit on a medium-term view. Yet, risks in the short term may continue to be skewed towards a renewed flight to quality, after a week when hope has been ascendant relative to fear. We remain cautious that in Ukraine, Putin may want to score further ‘wins’ via an escalation in hostilities before agreeing to a ceasefire.  

Meanwhile, it appears that Covid news in China also represents potential for a risk-averse move. Worryingly, it seems that low vaccination rates among the elderly and poor performance of the Sinopharm vaccine are leading to increased incidence of serious illness and death in Hong Kong and China, relative to the experience in other countries where infection rates have spiked. This suggests that further lockdowns could follow on the back of Shenzen, as we are sceptical that a policy of zero Covid can triumph, given the transmissibility of the Omicron variant.

Ultimately, we think policymakers in Beijing will alter course and learn to live with Covid. But in the short term, newsflow could get worse before it gets better.

A climate of short-term uncertainty suggests that it is appropriate to run risk at relatively modest levels until the outlook becomes clearer, or until valuations become so compelling (or unattractive) that a more assertive view is required. For now, there seem to be more opportunities in cross-market and cross-sector trades and we are happy to look for dislocations, or new issues, to add exposure. 

Emerging markets remain volatile, though sovereign credits that had performed poorly over the past month have rallied from levels we thought were oversold in the past week. With long-dated euro-denominated bonds from countries such as Romania and Mexico paying 400-500bp over Bunds, we feel that these investment-grade credits offer value; we have been happy to add on a dip and we look for the recent underperformance to reverse.

We continue to hold a constructive view with respect to the US dollar, looking for the US economy to outperform in 2022. Meanwhile, the EU current account surplus may contract by more than 50% as a function of higher energy costs. We think that commodity currencies such as the Australian dollar should outperform, while importers such as India are more likely to experience FX weakness.

Looking ahead

It is worth pausing to reflect that in the US we have seen an end to the 0% rates era. With inflation trending higher, a return to zero interest-rate policy (ZIRP) seems very unlikely in the foreseeable future. 

Moreover, it appears that interest rates are on a journey back to neutral, with liquidity set to be drained as policy turns. This policy exit appears to represent downside potential to risk assets. In addition to geopolitics and China Covid risks, this suggests it is wise to proceed with caution. 

Falling bond and equity markets have seen industry-wide redemptions from UCITS funds, representing a technical risk at a time when liquidity conditions remain relatively poor.

Stepping back for a moment, it is clear that we are living through some pretty seismic shifts in the global macroeconomic picture, as well as in politics. In that context, it is right to question what is compelling to own and where can we wait for more interesting entry opportunities.

Regarding Russian assets, we think these are destined to remain in the isolated wilderness for years to come. Regime change may be required before sanctions are lifted, and it is fair to say that Vlad has done a good job of completely rubbishing his country’s medium-term prospects in addition to the untold suffering that has been unleashed in what seems a very pointless conflict.