Fixed Income Boutique

Central banks are in a fighting mood


Yann Lepape

Head of Macro Strategy Platform, Portfolio Manager

Meet Yann


Ludovic Colin

Co-Head of Fixed Income Opportunities, Portfolio Manager

Meet Ludovic

| Read | 3 min

The cycle and the spreads: 10 May 2022

  • An aggressive Fed supports the USD and higher risk premia
  • The US labor market to cool down
  • There are still opportunities to exploit in EM sovereign spreads

The aggressive (expected) hiking cycle impacts the USD and risk premia


The Fed hiked its policy rate by 50 basis points last week as expected, and implied that the next two hikes would also be 50 bps each, reducing the risk of even larger hikes. In addition, the shrinking of the balance sheet will begin (see Tribune Nr. 18). Of course, depending on the growth/inflation pattern, the expected path can be modified. Mr. Powell added that normalization might be “painful”.

In other developed markets, central banks last week also continued to tighten policy, some, like the Reserve Bank of Australia and the Riksbank (Sweden), even surprised markets. But the US economy being the most overheated, the Fed is among the most aggressive.

The Fed’s aggressive (expected) hiking path – plus global uncertainty, including Chinese policies – support the USD. Since the invasion of Ukraine started, and commodities’ prices surged, the USD appreciated by 7.3% against a basket of developed market currencies. The sharpest move occurred against the JPY, as the Bank of Japan has not signaled any measures against rising prices yet. Even in the Eurozone, rate hikes are now forecasted – a return to 0% by end of 2022 indeed looks set as a minimum.

We think that the sharp contrast between last week’s Bank of England’s gloomy outlook and the Fed’s belief about a soft landing is quite interesting. There are indeed idiosyncratic arguments to expect with more certainty of a hard landing in the UK, and the GBP depreciated accordingly last week. This anecdote also illustrates the greater uncertainty surrounding the future economic path, justifying higher risk premia in all asset classes (see Tribune N. 19).

The US labor market to cool down soon? Central banks would appreciate that


In April, the US economy created 438,000 jobs (NFP), as in March, a strong number given the growth deceleration. The employment component of the ISM, as well as the NFIB survey, e.g., small and mid-sized companies’ opinions, rather pointed to lower figures. Now that the labor market has fully recovered from the pandemic and reached full employment, a return to a cruising speed (200k-250k) would make sense in the next few months.

Service sectors contributed by a bit more than 80% to the figure, and close to a quarter comes from the trade and transportation sector. Construction has been close to flat, which is hardly a surprise given the expectations in the housing activity.

The number of hours worked overall – a good proxy for GDP – continued to grow solidly on a yearly basis, albeit at a lower pace than in March. Lastly, wage growth stabilized at 5.5% in April, after 5.6% in March, avoiding creating additional pressure on the Fed, but also the other central banks.

There are still opportunities to exploit in EM sovereign spreads


Emerging market sovereign spreads have widened significantly since the invasion of Ukraine. While there has been some differentiation with commodity exporters outperforming importers, there are plenty of opportunities to exploit in a market that sold off without respecting some fundamentals. The chart above shows the changes in the current account balance projections for 2022 by the IMF in the last six months (X axis) compared to EMBI spread changes (Y axis)

Some movements make perfect sense. Among oil exporters (all towards the right of the chart), high yield (HY) countries like Oman, Iraq, and Bahrain have seen their spreads tighten and investment grade (IG) oil exporters like Saudi, Kuwait, UAE, and Qatar, which already had tight spreads before the war have held on well despite the broader sell-off among EM IG countries – packed in the middle of the chart above.

Towards the top of the chart, there are idiosyncratic stories that can explain some of the outliers like the ousting of the prime minister in Pakistan coupled with its large external financing needs; or the turn to left-wing populism in Honduras.

Others have been unduly punished: Kenya’s sell-off makes little sense given that its current account deterioration is in line with the median, its upcoming presidential election appears like a non-event for markets, and its IMF program is on track. Likewise, Egypt has requested an IMF program, received large pledges of financial assistance from Gulf countries, and it isn’t worse off than the median country in terms of current account deterioration, yet its spreads are much wider than three months ago.