09 December 2021
Recent inflation prints, central bank comments and Omicron headlines have been moving markets. We reflect on what it all means for fixed income investors.
Recent macro data suggests that bond markets may need to contend with central bank “optionality” to tighten monetary policy sooner rather than later. The US November payrolls report showed strong job growth despite the non-farm payrolls number coming in below expectations (210,000 vs. 550,000). This report has not altered the Federal Reserve (Fed)’s more hawkish rhetoric of late. Notably, the US Consumer Price Index (CPI) jumped to 6.2% year over year (yoy) in October, the highest reading in 31 years, which materially changed the Fed’s inflation outlook. While inflation is expected to moderate in 2022, it should remain above the Fed’s mandate and the risks appear skewed to the upside. Indeed, Fed chair Jerome Powell affirmed the end of the “transitory” story by stating that the 15 December Federal Open Market Committee (FOMC) meeting will include discussion of taper acceleration. In Europe, inflation has also become uncomfortably high with November’s eurozone Harmonised Index of Consumer Prices (HICP) surprising to the upside, with core and headline inflation rising 2.6% and 4.9% yoy, respectively. While this is likely to be a local peak, the assumption that inflation should gradually fall to comfortably below 2% would be complacent, in light of potential tailwinds to growth in the form of negotiated wage increases and strong consumer balance sheets. While European Central Bank (ECB) president Christine Lagarde has appeared reluctant to fully abandon the view that inflation is temporary, the ECB has clearly indicated it will begin asset tapering from March next year, opening the door for rate hikes in 2023. While the Omicron variant remains a global wildcard, early reports suggest that it is unlikely to alter hastened tapering timelines.
Developed market government bond yields have been buffeted around by headlines and data prints. During the month of November, the 10-year German Bund yield ranged between -0.10% and -0.39%; the yield on the 10-year US Treasury swung between 1.34% and 1.67%, peaking in late November following the FOMC minutes and the mention of a Fed accelerated taper, before falling 32 basis points (bps) in the final days of the month on Omicron fears. We witnessed similar turbulence in European rates, albeit to a lesser extent. Risk markets have been on the back foot, as tighter policy in the face of renewed uncertainty has weighed on sentiment, particularly heading into the year-end seasonal slowdown with less liquidity. For example, November was the worst month for excess returns (returns related to credit spreads) since March 2020 for high yield markets globally. However, barring a severe outcome from the Omicron variant, we expect investors to look through this Covid-19 wave and focus on the normalisation of monetary policy.
Developed market government bond yield turbulence following macro headlines and policy shifts
The technical backdrop is less rosy for global rates than in prior months, as central banks pivot from the transitory narrative to optionality in tightening policy. However, the less hawkish tone from the ECB, compared to the Fed, creates a slightly more favourable technical backdrop in Europe than in the US. Nonetheless ECB policymakers have clearly indicated that asset purchases will be tapered in March 2022 once the Pandemic Emergency Purchase Programme (PEPP) ends, meaning the monthly run rate is likely to fall from about EUR 90 billion in Q1 2022 to roughly EUR 20 billion over time. This should lead to a sizeable swing in eurozone net supply into positive territory, following many years of negative bond supply, net of quantitative easing (QE). In the US, the reduction in Treasury purchases is currently expected to accelerate in mid-January, bringing down the pace to USD 40 billion per month. Looking at demand, we have seen consensus short positioning across developed market rates, although these shorts were slightly reduced with the emergence of Omicron.
What does this mean for fixed income investors?
The two catalysts for the recent sharp moves in government bond yields were the emergence of the Omicron variant and the central bank pivot away from the “transitory” narrative. On the former, we believe new variants are an important tail risk to the central case that the pandemic impact is fading. On the latter, we think that underweight positions in duration in countries where policy normalisation is well underway should be monitored in tandem with central bank communication. Similarly, shorter-duration risk assets look compelling in an environment of low default risk where rates detract from total returns over the coming months.
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