The official plan of the ECB is to raise rates after concluding the bond/PPP purchase program in the third quarter of 2022, but: Inflation (+7.4% in March), the weakness of the Euro (-5.5% YTD against the dollar) and the Fed (+50 bp increase expected in May) invite the ECB to go faster. Wunsch (Belgium) does not rule out seeing the deposit rate positive in 2022 (vs -0.50% today), Nagel (Bundesbank) advocates making the first increase in July and Guindos (vice-president) does not rule out anticipating the end of the APP Q2 2022? The German 2Y IRR trades accordingly and rises to 0.21% (+88bp).
Outlook for the next 2 weeks for Fixed Income
interest rates
The central banks (BCs from now on) have it clear. It is time to normalize/tighten monetary policy (rising rates & balance sheet/ liquidity reduction ) because: the global economy is growing at a high rate (+3.6% estimated by the IMF for 2022 ) despite the bottle (COVID-19 in China), the Russian invasion of Ukraine (raw materials on the rise) and the change for the worse in Confidence indices (households & companies). The savings accumulated during the pandemic is a safety net/liquidity buffer and with few exceptions (Spain), the Unemployment Rates are at historical lows (~3.8% in the US & 6.8% in the EMU).
Outlook:
The path initiated by the Central Banks is not easy to follow because:
- Execution risk is high – impact on jobs/growth & markets/valuations
- The IMF warns of high indebtedness after COVID-19. The BCs try to avoid the stagflation experienced in the 70s/80s (high inflation & low growth), but the risk of recession increases. 2023?
- The increase in inflation is mainly explained by supply factors (raw materials & bottlenecks)
Time will tell if the BCs’ plan is successful, but bonds face a challenging environment because:
- The Fed wants to reduce the balance – now at 8.9 Tr.$ vs. 4.2 Tr.$ pre-COVID-19 – at a rate of 95,000 million dollars/month, Powell assumes a rise of +50 bp on 4 May (up to 0.75%/1.0%) and does not rule out seeing 2 or more 50bp hikes after
- The prospects for long-term inflation (swap 5/5Y) do not ease and invite us to think of an even more hawkish/hard tone from the BCs (bond sales?)
Strategy
The return/risk binomial is still not attractive – negative real rates & high volatility -. The main objective of our investment strategy is to minimize damage, which is why we insist on
- Keep duration risk low
- Avoid HY (low credit quality)
- Prioritize American credit to the detriment of the EMU – the main victim of the Russian invasion of Ukraine.