23 AUG, 2022
By Florian Späte
Since mid June, international bond markets have shown a clear change in direction compared to the previous months. Yields have dropped significantly driven by both receding real yields and lower inflation expectations. Disappointing macroeconomic releases have triggered concerns about a forthcoming recession.
At the same time, central banks kept their hawkish rhetoric and backed up their words with action. Market expectations still price further steep rate hikes for most major central banks (except the BoJ), but these have come down as of late with the expected peak of the cycle trimmed and brought forward. Hence, financial markets forecast that central banks will act quickly but the end of the cycle is seen to occur already in Q4 2022 (Fed) and Q1 2023 (ECB), respectively.
Going forward, we do not expect yields to plummet. Inflation readings are yet to peak on rising energy costs and broadening price pressures. Furthermore, central banks will continue to stress their commitment to tame inflation and front-load hikes in the months to come. The US 2-yr/10-yr curve already inverted amid the additional downward pressure on long-dated yields. Following the 90 bps decline in 10y Bund yields from the peak, markets have already priced a good chunk of the deteriorated macroeconomic outlook.
Furthermore, term premiums have decreased in recent weeks despite a high level of volatility. As both the Fed and the ECB have effectively abolished their forward (mis)guidance and turned to a data-dependent, meeting-by-meeting approach, yield uncertainty is set to rather increase and will keep bond market volatility on a high level.
Accordingly, we see scope for term premiums to rise again going forward.
However, given the macroeconomic environment, we expect only a limited yield increase of core benchmark bonds as the growth slowdowns is set to extend. Gas supply remains a key risks: Russia has resumed its deliveries, but now at only 20% capacity. A full stoppage of delivery would deepen the recession and bears a downside risk also for Bund yields.
Overall, we forecasts core bond yields to rise only moderately on a 3-month horizon (US: 2.85%, EA: 1.05%). Furthermore, we assume that the high point in the US (together with the approaching peak in the key rate cycle) will already be reached in the next few months. In contrast, the rise in EA yields should continue over the year.
EA non-core government bonds remained under pressure in recent weeks as a number of factors (e.g. uncertainty about ECB policy, political imponderables in Italy, recession fears) contributed to the underperformance.
Despite the increased spread levels we do not forecast a trend reversal as non-core bonds are still not cheap yet (see chart on the left). What is more, the ECB remained rather vague with respect to the TPI. We regard the unlimited size and the pari passu clause as necessary conditions to be able to exert any impact at all on markets. But the conditions defined for activating TPI appear vague and leave plenty of discretion for the ECB. We expect financial markets to test the ECB’s commitment.
Furthermore, TPI is announced in an environment of political uncertainty in Italy. On September 25 general elections will take place and the formation of a new government might take some time, triggering problems regarding the distribution of NGEU funds. According to current polls a right-wing government with the participation of Fratelli d’Italia – which is deemed to be much more euro-sceptical than the former government – is possible. Even in case TPI will be activated (which is far from certain as it is not designed to prevent idiosyncratic factors) the maximum remaining maturity of purchased bonds is 10 years. This leaves very longdated BTPs particularly vulnerable and we expect the 10-yr/30-yr BTP spread to widen further down the road.