Fundamentals

Central banks in the US and Canada have clearly flagged multiple rate hikes in 2022 and the Bank of England has already hiked twice. Until now, the ECB has been able to avoid this hawkish turn as policymakers had expected inflation to peak in November 2021. However, eurozone inflation has continued to rise. Driven by energy prices, inflation hit a record high of 5.1% in January, well above the market’s forecast of 4.4%. Things haven’t stopped there, the 2022 inflation outlook is now tracking more than 1 percentage point above the ECB’s December 2021 projections at 3.2%. Combining this with recent eurozone unemployment hitting record lows of 7% and minimum wage hikes expected before the end of the year, the ECB has been forced to walk away from the guidance that a rate hike in 2022 was “very unlikely”. The market now expects two 25 basis point (bps) hikes by the end of the year, though the ECB feels this is excessive. If we’ve learned anything from the past, however, it’s that the ECB’s expectations can quickly change. Upside surprises in inflation and hawkish rhetoric from central banks have yet to spill over into corporate fundamentals. Balance sheets remain strong and seem able to stomach the higher borrowing costs that come with rate hikes.

Quantitative valuations

European spreads reacted to the ECB’s hawkish shift with broad based widening across the risk spectrum. The spread between Italian and German 10-year bonds — a key measure of stress in eurozone bond markets — rose to 1.63%, its highest level since July 2020. European investment grade credit and high yield saw similar moves, with spreads widening by 12 bps and 22 bps month-to-date respectively, though these levels are still relatively tight in a historical context. As such, spreads could continue to widen as the ECB prepares itself to tighten monetary policy. At the moment the spread moves have been orderly and in line with expectations, as displayed by the resilience in the lower quality high yield market, showing that investors aren’t worried about a credit event. Further orderly widening shouldn’t cause concern; however, any significant spread widening could signal a policy mistake by the ECB and end the cycle early. (All data as of 9 February 2022).

Technicals

The seemingly endless support from the ECB’s bond buying programme that we witnessed in 2020 and 2021 is expected to come to an end later this year. With this fall in demand, it will be up to the market to absorb supply, which could put further upward pressure on spreads. The ECB has been able support tighter credit spreads until now and removing this support could be seen as a risk event. Looking at past cycles, EMU (European Monetary Union) spreads widened as the ECB tapered its bond buying, though after purchases stopped the market was able to absorb the additional supply relatively well and spreads tightened. As of 9 February 2022, we are still in the midst of the ECB’s taper programme and further widening could be expected. We’ve seen outflows across European high yield (€70 million) and investment grade credit (€505 million) so far this year, with the most material outflows happening on the back of the ECB’s hawkish shift. In the rates markets, investor positioning surveys point to consensus shorts in Germany and peripheral Europe, which could put a limit on how high yields can move.

In previous ECB tapering cycles, EMU spreads tightened after purchases stopped

Source: Bloomberg, J.P. Morgan Asset Management. Data as of 9 February 2022.

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.

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