It has become clear that the current inflation pressures are not simply transitory. Supply-side disruptions have proven more persistent given the drawdown in goods inventories, while labour shortages could take months to decline. ‘Transitory’ inflation looks likely to last 12 to 24 months. This could be long enough to dislodge inflation expectations.
This is an abridged version of our latest fixed income outlook
US growth, inflation and the Fed
In the US, the fiscal response to the pandemic may well have been excessive. Indeed, easy policy has triggered an asset price boom and financial stability concerns. This has prompted the start of policy normalisation, beginning with a reduction of large-scale asset purchases by the Federal Reserve.
We believe that US economic growth will pick up in Q4 2021 and 2022 as the Covid Delta variant fades, businesses reopen, hiring reaccelerates, and consumers resume spending. The economy should re-attain full employment in H2 2022.
Inflation is likely to be persistent. This should convince the Fed that from September 2022, policy rate rises are warranted at a pace of 25bp per policy meeting.
Looking at longer maturities, the Fed’s intolerance of persistent inflation overshoots means the argument for pricing any inflation or real yield risk premia is weak. A swing from a net negative Treasury bond supply in 2021 to a surplus of in 2022 should cap the room for any further widening in breakevens, and improve the prospects of a rise in real yields. We believe it will be monetary policy, rather than Treasury supply, that will be the primary driver of the yield curve.
Our 2021 year-end target for the 10-year US Treasury yield is 1.75%, and 1.90% by the end of Q1 2022. We are underweight duration in 5-year Treasuries to position for a repricing of the path of policy rates.
On inflation, we believe the new longer-run fair value for 10-year BEIs (breakeven inflation) is likely at around 2.30%, but current inflation concerns are motivating steady inflows that will keep 10-year BEIs between 2.50% and 2.75%. We are positioned flat BEIs.
On the yield curve, a more hawkish Fed will eventually reduce inflation and real yield term premia on longer maturities. That raises the odds of earlier, but more limited rate rises – hence we have a curve flattening bias.
Investors seem to be sceptical of the ECB’s inflation assessment and its new forward guidance. The lack of guidance on what would replace PEPP asset purchases at the end of March 2022 has frustrated the market, and price movements in ‘peripheral’ bond markets have highlighted their vulnerability to the eventual withdrawal of ECB bond buying support.
It is likely that shorter-dated real yields and BEI rates will remain well supported in Q4. Our view is that slack in the labour market will likely weigh on wage growth, and longer-term inflation expectations will be contained. As such, we have a yield curve steepener and a small short position in BEI at the longer end of the curve.
Increase in HICP inflation not limited to energy costs
The headline harmonised index of consumer prices (HICP) for the euro area reached 4.1% YoY in October, up meaningfully from the roughly 2% level seen between May and July. While energy was the main driver of inflation, prices also accelerated in other categories including logistics costs and prices of services. Headline HICP is expected to have hit around 4% YoY in November.
Inflation is likely to stay at above 2% in the first half of 2022 until base effects set in and push it down. It is too early to assess whether second-order effects from the persistent supply-side disruptions and surging energy prices have started to feed into – wage – inflation.
ECB monetary policy
The ECB faces difficult decisions in December about what to do after Pandemic Emergency Purchase Programme (PEPP) asset purchases end. Given the continued price pressures, some council members worry about inflation proving more sustained. Others consider the inflation forecasts (1.7% in 2022 and 1.5% in 2023) to be too low. What seems clear is that the size of the asset purchases will be scaled back meaningfully once PEPP is out of the way.
In terms of duration risks, central banks moving towards stimulus withdrawal should put upward pressure on yields. In the eurozone, investment flows from the Next Generation EU funds and individual countries’ recovery plans will likely keep growth at above the long-term trend for the coming quarters. This suggests that the sell-off in yields will likely continue.
However, rising inflation expectations and higher input costs might cut into corporate profits and consumers’ disposable incomes, creating significant downside risks to growth.
Corporate credit still in favour
Developed market corporate bond spreads have remained low in absolute terms. Given that the macroeconomic environment remains positive and that monetary policy is supportive, even as the degree of support lessens, we do not expect spreads to widen meaningfully in the months ahead.
Fund flows have continued steadily as investors greatly favour corporate credit over sovereign bonds. Challenging valuations, on the other hand, leave little room for further tightening. The outlook for credit quality has if anything improved given the latest company results.
We are neutral to negative on duration for both Europe and US given the outlook for interest rates. We prefer cyclicals to non-cyclicals as the economic growth outlook remains positive in Europe and the US for both investment-grade and high-yield.
In view of the persistent recovery, we expect company managers to shift their focus to spending and growth. While this benefits shareholders, the outcome may not be as positive for credit spreads. We will focus on security selection and on tactical valuations amid a greater dispersion of returns.
Emerging market debt offers value
The upward pressure on inflation has forced some central banks to raise rates and most of the others are now at the end of their cutting cycle. While this is a headwind for EM rates, we believe there are selective opportunities in high yielders.
We believe EM bonds still offer more value versus US peers given their current valuations. While US IG and HY bonds trade at historically narrow spreads, there is room for spreads to compress further for EM IG and HY bonds. EM HY looks the most attractive, especially after the recent sell-off.
Asia high-yield in particular has become appealing. The risks related to property developers in China and a hawkish Fed has led to flight-to-quality spread widening. While defaults are likely to rise in China, spread widening has made the region attractive on a relative value basis compared to other EM regions and global HY.
The recent sell-off in emerging market currencies has left many starting to look attractive again.