Ardea Investment Management examines key fixed income market themes for 2022
As each year draws to a close, it's common for investment managers and banks to publish predictions for the year ahead. In fixed income, these notes tend to be heavily focused on the macroeconomic and central bank policy forecasts which drive yield predictions. Forecasting is a tough job. Even the most seasoned market professionals have a chequered history in accurately predicting key variables like growth, inflation, and the level of bond yields.
We highlight five key themes that will impact the risk/reward balance for fixed income in 2022:
1. high expectations and risks to global growth;
2. peak inflation;
3. peak QE and bond supply/demand dynamics;
4. rate hikes to further un-anchor yield curves;
5. cross-market rates divergence and volatility.
A common link among these broader market themes is the rising level of macro uncertainty. For relative value strategies, this uncertainty is likely to manifest in further distortions in yield curve shapes, interest rate volatility and changes in the relationship between bond and interest rate derivative curves.
1. High expectations and risks to global growth
Since mid-year 2021, global growth momentum has been slowing. This slow-down helped suppress bond yields and dampen risk sentiment through Q3, particularly as the US confronted the delta COVID wave. But that was quickly forgotten by markets in October amid optimism about future growth prospects and as the ongoing surge in inflation led to central banks signaling tighter policy.
The base case for many investors looks like global growth slowing from a peak of 5.9% in 2021 to a still solid 4.9% in 2022. For the advanced economies that bond markets track more closely, growth is expected to ease from 5.2% in 2021 to 4.5% in 2022, which would return these economies to pre-pandemic trend paths.
Importantly however, these optimistic base case forecasts are subject to substantial risks that are likely to periodically drive volatility in bond markets and challenge risk assets valuations. One of the biggest assumptions behind relatively optimistic economic forecasts is that the pandemic will gradually fade. The emergence of yet another new variant of COVID in recent weeks is challenging this consensus view. Much will hinge on the effectiveness of vaccines, emergence of new treatments and government policy responses to any rise in cases. Optimistic forecasts and many asset valuations depend on the world overcoming COVID and there remains the risk of further setbacks on this front in 2022.
2. Peak inflation
Inflation surged in 2021 as demand recovered strongly from the depths of the pandemic in 2020, while the supply side of economies has struggled to keep pace. Headline CPI in advanced economies is running at the highest levels in a decade or longer.
The consensus among private sector economists and central bankers is that inflation pressures will ease substantially in 2022 – as early as Q1 – as the supply side of economies catches up. A closer examination of CPI prints reveals some highly concentrated and temporary drivers such as rising energy costs. Supply-chain bottlenecks and pent-up demand for goods are expected to ease and contribute to a significant deceleration in CPI. Market participants, however, are less confident. The experience at the coal face through 2021 for fixed income investors has been one of persistent over-shooting of inflation outcomes relative to forecasts, as supply shocks persisted. Chart 1 shows that the G10 inflation data surprise index reached decade highs alongside rising market implied inflation expectations.
G10 inflation surprises and breakeven inflation rates
The Fed recently dropped its key "transitory" message, acknowledging that inflation is more persistent, which could see them speed up the pace of QE tapering. A key risk scenario for 2022 is if markets question the credibility of central bankers in containing inflation, resulting in even higher long-term inflation expectations or aggressive repricing for higher policy rates. This outcome would likely see more significant adverse spillovers into risk assets which have mostly weathered bouts of interest rate volatility in 2021. Conversely, a sharper pull-back in inflation pressures early in the year could see fixed income markets remove some of the rate hike pricing factored into the front end of yield curves over the last few months. In either case, we see potential for higher rates market volatility while high inflation uncertainty persists.
3. Peak QE and bond supply/demand dynamics
Central bank balance sheets will likely peak early in 2022, removing a major tailwind behind all assets since March 2020. The pace of QE purchases is set to imminently slow in the US and Australia, while central banks have stopped buying bonds altogether in Canada and New Zealand. In Europe, the Pandemic Emergency Purchase Program (PEPP) is due to expire in March 2022.
The impact on bond markets - and by extension other asset classes - can be thought of as comprising both stock and flow effects. That is, both the size of the central bank balance sheets and flow of after-QE net supply work to lower yields. The overall size of balance sheets will remain massive, with central banks not selling their bond holdings.
There is still pressure towards rising long-term yields as QE fades. From a flow perspective, in an environment where large, price-insensitive buyers have stepped away, bond markets will be even more sensitive to periodic swings in fixed income fund flows and changes in bond supply. Fortunately for policymakers, the pull-back in QE coincides with a projected improvement in fiscal balances, leading to lower gross bond supply in 2022 across advanced economies. Periodic cheapening of sectors of yield curves in reaction to changes in supply/demand dynamics is likely to create relative value opportunities in 2022.
4. Rate hikes to further un-anchor yield curves
In October 2021, interest rate markets priced a significant increase in policy rate expectations over the next two to three years in the wake of stronger inflation data, hawkish central bank comments and a positioning washout among highly levered investors. While positioning shifts tend to fade quickly, the sheer amount of stimulus still yet to be unwound means that volatility in the front end of interest rate curves has structurally reset higher. This shift has significant implications for fixed income portfolio construction and yield curve strategies.< br />
Another key theme is the amount of overall tightening factored into interest rate curves. In some markets, 2y and 3y ahead forward rates are trading higher than 4y and 5y ahead forward rates. One interpretation of this pricing structure is that a type of policy mistake is being priced. That is, rate hikes may go too far and will have to be quickly stabilised or reversed. More generally, markets doubt economies can handle a much higher peak in rates in the cycle because of debt levels and/or long-term inflation and growth dynamics. Or in other words, the market expectation for the neutral policy rate (the rate at which monetary policy is neither expansionary nor contractionary) will be materially lower than in previous cycles.
These assumptions can change quickly. However, medium to long-term rate expectations have previously tracked wider trading ranges with policy normalisation cycles in the early stages. In the US we note the Fed and some private sector economists see neutral policy rates closer to 2.5% than the 1.4% currently priced into long-dated forwards. If inflation is higher for longer or potential growth rates are revised up, markets may view central banks as behind the curve, which could reset longer-term rates higher.
5. Cross market rates divergence and volatility
In 2022, bond markets are likely to show greater divergence, as progress towards central bank goals varies by region. This cross-market difference could be exacerbated further by any new COVID variants, as governments take different approaches to social distancing and fiscal support.
In terms of central banks, clear differences are already emerging. At one extreme, the RBNZ has hiked twice already and is widely expected to remain aggressive in its tightening policy through 2022. At the other end of the spectrum, the ECB is expected to keep rates on hold, but instead adjust QE in 2022, while the ice age in JPY rates looks set to continue. Most economists and investors expect the BoE to hike sooner than the RBA or Fed, but that the latter two central banks will ultimately take rates higher in the cycle. The central banks themselves are providing mixed messages on how much and when highly accommodative policy will be unwound.
For example, the BoE recently wrong-footed markets on the timing of a hike, while the RBA continues to talk down the likelihood of a hike before 2023.
Overall, bond market performance and the volatility of returns will likely vary throughout 2022. For investors, this will likely create additional uncertainty over duration allocations, but also cross-market yield spread opportunities.
This material has been prepared by Ardea Investment Management Pty Limited (Ardea) (ABN 50 132 902 722). Ardea is the holder of an Australian financial services licence AFSL 329 828 and is regulated under the laws of Australia.
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