Fixed Income Boutique

The more aggressive you are now, the more dry powder you’ll have later

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Yann Lepape

Head of Macro Strategy Platform, Portfolio Manager

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Ludovic Colin

Co-Head of Fixed Income Opportunities, Portfolio Manager

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| Read | 3 min

The cycle and the spreads: 21 June 2022

  • An acceleration in the tightening path at the Fed to dampen demand
  • The ECB reminds us it cares about EMU fragmentation
  • Outflows in EM debt – will real rates trigger a stabilization?

The Fed’s new pivot provoked a sharp move of the three-months dollar yield futures contract

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The US Federal Reserve hiked its policy rate by 75 basis points to 1.5% last week despite its previous forward guidance. Two weeks earlier Fed Chair Jay Powell had ruled out a 75 bps increase. What happened? May inflation rebounded and surprised on the upside. But the trigger for this turnaround was more likely the sharp rise in long-term inflation expectations, breaking the (U. of Michigan survey’s) last decade’s range, a few hours after the CPI data and a few days before the FOMC.

In the face of the risk of de-anchoring inflation expectations, the Fed's objective is no longer to return to a neutral stance, but to become restrictive and raise rates sufficiently to slow demand, credit, and ultimately prices. Given that the effects are not immediate and that the current context is unprecedented, the calibration – how much growth to sacrifice – will prove tricky.

The Fed, which has also published new forecasts, now admits the possibility of a recession. But it would be relatively benign, since the unemployment rate would rise from 3.8% to 4.1% in 2024, "only" slightly above full employment. Growth would slow to 1.7% in 2022 and 2023 and inflation decelerate from 5.2% in 2022 to 2.2% in 2024. The reality will for sure be different.

However, we believe it is important to underline that by accelerating the pace of rate hikes now, at a time when the economy is proving highly resilient, the Fed is more quickly putting dry powder on the side: it will be able to stimulate the economy again when growth comes too close to recession, from the second half of 2023 onwards (upward arrow on the chart), if we believe investor expectations.

EMU sovereign yields fragmentation: worrying signs, but way off 2011, and a vigilant ECB

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Even if both institutions are clearly committed to monetary normalization, the ECB's current concerns differ from those of the Fed: excess consumption in the US, risk of fragmentation for the EU. In the absence of an announcement of a new tool to "regulate" intra-European sovereign spreads, the spreads indeed continued their widening path last week.

But the violence of the movement, with a peak Bund-BTP spread of 2.45%, ended up provoking an emergency meeting at the ECB, with a promise that a tool would be put in place and proposed as early as this summer. The details are not yet known, but it could be similar to the OMT (Outright Monetary Transactions), which was set up in 2012, but without certain constraints.

For the ECB, it was also a question of sending a message that it would not let the situation get out of hand, that it also felt responsible for monitoring spreads, which should nevertheless reflect the relative risks associated with the economies, and not “unwarranted” fragmentation. In the same vein of showing the institution's involvement, the Bank of Japan expressed concern about the yen's depreciation (massive, over 20% since October 2021).

Outflows in EM debt did not stop the bleeding, but real rates could become supportive

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Outflows from emerging market debt have continued over the past six weeks, both in hard-currency and local-currency issues. Outflows are estimated to have reached around 7% of assets under management since the beginning of the year, the highest level in decades.

Asset class outflows and performance reinforce each other. Emerging market external debt is down by 19% year to date, and EM local by 14.5%. The most important factor driving these outflows is the violent repricing of global interest rates, which has driven large losses for all fixed income asset classes, including developed markets – global credit lost 16% and developed sovereigns 15%.

What could stop the bleeding? A return to positive real rates, preferably through disinflation, would be a great support. Interestingly, looking at expected inflation, the five-year forward real rates turned positive in the US, almost reaching 1% now. Since 2020, it was in negative territory. A depreciation of the USD, currently largely overvalued against most currencies, could also be a trigger. It would probably go with the disinflation path.

Emerging markets are not the US, and the measures of forward inflation are less reliable. Nevertheless, the EM external debt index (EMBIGD) now yields 8.3% almost as high as current US inflation (8.6%) and much higher than future expected inflation – 2.9% over the next five years as per break evens. In other words, the trade starts to be attractive at least for US based investors. Similarly, EM local debt currently yields 7.1%, not yet enough to compensate for current EM inflation (7.7%), but probably enough to compensate for expected future inflation. Only confidence that inflation has reached a peak is lacking.