13 January 2022
Behind the curve
Markets have started to price in the risk that the Federal Reserve (The Fed) is behind the curve in tightening monetary policy. We determine what this means for both government bonds and risk markets.
Fundamentals
What a difference a new year makes. The rhetoric for much of 2021 was that the Fed may keep rate hikes on hold for multiple years – this now seems like a distant past. At the start of 2022, the market has priced in a quicker than initially anticipated tightening in monetary policy, with the Federal Open Market Committee (FOMC) announcing in its December meeting that it will double the pace of tapering from $15 billion a month to $30 billion. This means that tapering could be wrapped up by the end of March, clearing the path for multiple rate hikes this year. The main culprit for this change? A shift from describing inflation as “transitory” to something that is more permanent. US inflation reached its highest level in decades, with headline and core CPI (consumer price index) for December printing at 7% and 5.5% year-on-year respectively. This is not just secluded to the US: eurozone HICP (Harmonised Index of Consumer Prices) reached a new all-time high at 5%. Despite this, economic growth remains strong and corporate health is resilient as many companies are able to pass these inflated costs to consumers.
Quantitative valuations
US Treasury yields have made significant moves so far in 2022. In just seven trading days, the 10 year yield has climbed 23 basis points (bps) to 1.74%, the highest level since March 2021. Interestingly, developed market high yield bond spreads have been much more subdued, moving only 3 bps wider since the start of the year to 319 bps. This would suggest that investors are more comfortable owning credit risk than duration risk. High yield spreads benefit from being able to offset a rise in underlying government base rates. However, spreads have come a long way, tightening 64 bps last year, meaning they are now 717 bps lower than their pandemic-induced wides reached on 23 March 2020 and are approaching their post financial crisis lows of 300 bps. Therefore, there is not much more room for them to tighten if government yields continued to rise at a similar pace. Our base case is for them to remain range bound, as we don’t think there is impetus for a material repricing higher of the market’s already elevated expectation for future inflation. (All data as of 11 January 2022).
High yield spreads have held up better than government bonds at the start of this year
Source: Bloomberg, ICE BofA Developed Market High Yield Constrained Index. As of 11 January 2022.
Technicals
Investors are clearly preparing for a more hawkish central bank cycle with recent positioning surveys showing increased shorts across developed market government bonds, particularly in US and UK debt. While this positioning may be warranted, there is the risk of overcrowding in consensus shorts and investors should watch out for any unwinding of this.
What does this mean for fixed income investors?
There has certainly been a shift in central bank messaging towards quantitative tightening. A combination of a tight labour market, accelerating wage growth and the continued above-target run rate of price inflation confirms the need for the Fed to finish tapering and start hiking rates over the next couple of months. We think the key balancing act for the Fed is that while it feels like it is behind the curve, it has to figure out by how much and how quickly it can move without creating disorderly swings in markets. We’ve seen the first knee-jerk reaction from government bonds, but this is yet to spill over as much down the risk spectrum to high yield bonds. Investors should be mindful of a potential tipping point later in the cycle when weakening growth and tightening policy coincide, but in the meantime we think the strong fundamental backdrop for credit will continue to be supportive, while the pace that the market prices in future expected rate hikes should become more manageable.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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