Global Head of Fixed Income Investment Strategists
2021 has been an environment characterized by strongly above-trend growth and above-target inflation, as shutdowns and economic restrictions gave way to vaccination campaigns, reopenings and surging demand for goods and services. This has led to a rising rate environment, but the path has not been linear. Yields surged higher in the first quarter of the year on the reflation narrative, giving way to a “delta dip” over the summer, but rates resumed their upward climb starting in the third quarter. In this context, sovereign rates have seen negative performance while riskier fixed income sectors have seen positive excess returns, as spreads have tightened since 2020 (Figure 1).
Figure 1: After the Summer Delta Grind, Sovereign Yields Are Backing Up as the Spotlight Shifts to Inflation Concerns
Going into 2022, all eyes are on inflation, as Consumer Price Index (CPI) prints continue to hit multi-decade highs. We expect inflation to begin to ease starting mid-2022, as the high second-quarter prints from this year present more challenging comps. However, volatility in monthly inflation will continue into 2022, with supply-chain challenges persisting beyond initial expectations. In this piece, we’ll discuss three key dimensions of our outlook for 2022:
Despite our expectations for a moderation in inflation in 2022, we expect a more hawkish stance from global central banks.
While higher rates year-to-date indicate that the markets also expect central-bank tightening, we believe that recent sovereign rate increases are overshot.
And finally, we believe that spread product will continue to remain relatively tight given strong credit fundamentals.
Central-Bank Pivot from Accommodation to Tightening
Amid a strong macroeconomic backdrop, we are seeing the shift from monetary accommodation to tightening. Central banks around the world have pivoted to more hawkish stances, prioritizing the withdrawal of stimulus that was performed via quantitative easing (QE). The Federal Reserve and others have begun tapering their COVID-era asset purchase programs; for example, the Fed announced in November that it would start tapering its $120 billion-per-month QE program at a rate of -$15 billion per month ($10 billion of Treasuries, $5 billion of agency mortgage-based securities [MBS]), with the aim to end the program by mid-2022. In addition, central banks have signaled that the first rate hikes since the pandemic began are on the horizon. Front-end yields have backed up accordingly, and interest-rate swap markets have pulled forward rate-hike expectations dramatically since September (Figure 2).
Figure 2: Global Monetary Policy Is Moving from Accommodation to Tightening
Market Implied One-Year Policy Rate Move (%)
Have Market Expectations Moved Too Far Too Fast?
Policy rate increases in 2022 seem to be a foregone conclusion, especially given the continuing stickiness of inflation, but have government yields moved too high too quickly? Possibly, for a few reasons. First, we think the longer-term structural low-growth, low-yield world (Figure 3) will not change materially as COVID transitions from pandemic to endemic in the coming years.
Figure 3: Global Demographic Trends Point to Continued Low-Growth, Low-Yield Environment Post-Pandemic
Second, while supply chain challenges and well-above-target inflation are expected for the next 6 to 12 months (at least), we believe these inflationary pressures will ultimately dissipate. Finally, while short-end yields have shot higher, long-end yields have been more anchored, leading to a bear flattening year-to-date. The modest uptick in the long end could imply that inflation and growth expectations are more muted and the short-end has moved up too fast. Despite the back-up in the front end, interest rate swap markets in the U.S. continue to price in a longer-term Fed Funds Rate of under 1.75% (Figure 4), well below the 2.5% reflected in the Federal Reserve dot plot.
Figure 4: Treasury Swap Markets Reflect a Policy Rate Under 2% Going Forward. Does This Suggest a Less Robust Recovery?
Fed Funds Path Implied by US Rates Market
Markets remain skeptical of just how much rates can rise from current levels on a longer-term basis — and so are we. We expect curves to flatten further as front-end yields continue to be pulled upward while the back end remains more anchored.
Improving Fundamentals Will Support Tight Credit Spreads
Spreads within riskier fixed income sectors like investment grade (IG) and high yield (HY) credit should continue to be well supported by a fundamental picture that has bounced back quickly after a challenged 2020. The overwhelming policy response during COVID, including central banks’ asset purchases of IG and some HY corporate bonds/bond ETFs, helped stabilize credit spreads quickly and limit the depth and breadth of the downturn. Within the current credit cycle, we have transitioned from downturn, to repair, to expansion in less than two years. As a result, IG corporate fundamentals in the form of leverage ratios, margins and EBITDA growth have improved markedly and are now back to pre-COVID levels (Figure 5). We expect credit spreads to remain relatively compressed moving into 2022 despite valuations already near long-term tights, based on strong fundamentals and foreign investors’ continued demand for yield. Lastly, the more upbeat “rising stars” backdrop will help enable a benign default and downgrade environment. Despite valuations, riskier fixed income spreads still handily outpace government yields and should be a good source of carry in 2022.
Figure 5: IG Fundamentals Have Quickly Bounced Back to pre-COVID Levels, Supporting Valuations
Risks to Our Outlook
Risks to our expectations are all centered around inflation. If we continue to see month-over-month prints near 1%, central banks may have no choice but to begin hiking policy rates quickly, thereby putting a damper on the recovery. High levels of inflation plus dramatically slowing growth is the worse-case scenario, as there are no easy solutions to deal with stagflation. On the other hand, inflation slowing rapidly to levels below the Fed’s 2% target would suggest that the structural low-growth, disinflationary forces (demographics and technology, among others) are stronger than we thought and would likely require fiscal policy to help address these challenges.
We expect global central banks to take on more hawkish posture in 2022.
While short-term rates have moved higher in response to potential rate hikes in 2022, we believe that the increase in yields and hawkish tone of the Fed could serve to accelerate the economic cycle.
Entering 2022, we expect yields to rise further in the front end as rate hike expectations continue to be pulled forward. Any back up in longer-maturity yields should remain relatively contained, resulting in continued curve flattening.
We expect credit spreads to remain tight, and investment grade credit should continue to be a good source of carry and incremental yield (over U.S. Treasuries) in 2022.
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