Monetary Policy Normalisation

Policy normalisation has remained the focal point over the past several weeks, with the abandonment of negative rates across developed markets. By retiring the “transitory” characterisation of inflation that it had held onto previously, the Fed has explicitly and deliberately chosen to exhibit a hawkish stance. The ECB followed the Fed upturn by opening the door to a possible rate rise in 2022, taking the markets by surprise. Other developed market central banks (the Bank of England, the Bank of Canada) have also taken the hawkish path, while a number of EM central banks have already tightened their policies. Moreover, some central banks want to proceed with balance sheet runoffs later in the year, a big change in timing compared to other tightening cycles. The pace of central bank asset purchases is expected to turn negative at the end of 2022, which represents a turning point. In this context, global bond markets continued to climb upwards, with an accelerated movement in January 2022, with sovereigns and credit markets putting in negative performances.

In terms of the G4 cycle, we see a business cycle that appears to be slowing somewhat, though we do not expect this trend to accelerate. The inflation cycle is still strong, ever growing, and is the primary driver of central banks’ hawkish stance. New central bank policy is likely to be the linchpin going forward as far as bond markets are concerned. Market participants have grown so used to central bank support over the past few years (and in fact since 2012), that any tightening activity or threat thereof has been accompanied by a significant increase in volatility, which is again likely to be the case in 2022. Political risk is also present, as the mid-terms in the US and general elections in France and Italy could be of vital importance and add to the uncertainty, as could the conflict in Ukraine (where the US and Russia appear to be sparring), the omnipresent trade wars and the continued fall-out from Brexit.

Rate: Maintain negative stance on US rates

The business cycle has been slowing in the US, though we are seeing some stabilisation of the consumption component, which is a positive. Other components remain very stable, indicating that the business cycle is improving and trudging along to the expansion stage. This provides positive support for the FOMC to continue moving towards monetary policy normalisation. Labour markets present a very strong picture in the US, with unemployment rates hitting lows, and strong non-farm payroll figures. The inflation cycle continues to be very sturdy, with the housing component being the weakest link (though much less systemic than in the past). Finally, on the very important issue of monetary policy in the US, we now have Fed Funds futures for 2022 pricing above the median rate implied by the dot plots. It appears that the FOMC will have to yet again mark its dot plots to the market. This points towards the frontloading of monetary policy normalisation, which includes the possibility of a 50 bps hike in March, consistent with the Fed’s eagerness to tighten. In this context, we maintain a short position on US rates. 

Relative Value Long NZ & Short AU

We maintain our negative view on New Zealand rates on the back of more positive economic data and the tapering of monetary support in the form of scale-backs in central bank asset purchases. The RBNZ seems priced for perfection. In Australia, we have seen strong numbers in employment and inflation. While the RBA was relatively dovish vs other CBs, current data (supported by the reopening of the economy) could push it to move in a more hawkish direction. In this context, we also hold a negative view on Australian rates. However, we do see some potential for a relative value trade involving a long position in New Zealand and a short position on Australia on the 10-year portion.

Relative value Long UK & Short US

In the UK, we saw some hawkish surprise from the central bank, with four members calling for a 50 bps hike. There was also an unexpected unwinding of the 20 billion sterling corporate balance sheet holdings, resulting in a bear-flattening in the UK curve. However, we believe that front-loading the rate hikes is unlikely to result in a greater number of hikes in the future. Furthermore, the energy price cap (starting in April), which is significant for lower incomes, means that there will be a continued squeeze on UK consumers, exacerbated by the tax hikes (for national insurance) about to go into effect. With this in mind, the five hikes that the market is pricing in appear to be too aggressive, and could result in some weakness in the UK economy, while the US economy looks like it will cope well with a tightening. In light of this, we believe that a  long position on UK rates vs. a short position on US rates should do well.

Strong Underweight on German rates

The overall framework is negative, both for core and peripheral rates in the eurozone. Regarding the monetary cycle, the ECB had already announced the tapering of its QE programme, but in its latest press conference, it did not close the door to rate hikes in 2022 (citing concerns about inflation), while also hinting at the recalibration of the QE programme.  We can expect a significant impact on net flows, and this will have a clear negative impact on core and non-core rates in Europe. In terms of positioning, there have been significant developments, with investors moving increasingly towards a neutral stance on non-core markets, which should continue. We expect a lot of supply on the market, which will not be compensated for by a declining asset purchase programme, a negative factor for Euro Duration. In light of improving growth and inflation numbers, we expect core rates to rise, especially given the tight valuations that they exhibit, thereby justifying our negative stance on Germany.

In Italy, while the re-election of Sergio Mattarella as President is a clear positive, we do see some tensions between the different parties, and with the election in 2023, this could lead to some instability. We have reduced our view of Italy to neutral, and we remain underweight on Spain, maintaining our defensive stance on non-core countries. On certain semi-core countries, we are also maintaining a negative stance (France in particular), while we turn neutral on Belgium (from a previously positive stance).

Slight Overweight on EUR Breakeven

Euro inflation surprised a lot of market participants in January, even the ECB, which decided to reassess its policy and left a lot of options open for the March meeting. Indeed, the Euro flash estimate for January came out at 5.15%, clearly driven upwards by the energy component that has been a driving force in terms of contribution to price pressures across all eurozone countries. Looking forward, euro inflation should remain high in H1, only decelerating more clearly in the second half of the year. In this context, we expect euro break-even inflation curves to flatten further, as short-end inflation expectations should remain well supported by high spot inflation data, while longer term inflation expectations are likely to be dampened by expectations of a less accommodative ECB. We maintain a positive stance on EU break-evens, though we did take some profit very recently, after their strong run.

Long position on commodity currencies vs USD

The oil rally continues to be a source of support for currencies like the Canadian dollar and Australian dollar. Despite a dovish RBA, we continue to expect the AUD to outperform the USD, driven by the current account surplus that has been maintained over a number of years. We also initiated a similarly small tactical position on the Canadian dollar, which should rally vs. the USD after a strong employment report in January. We expect the BoC to hike next month and remain supportive for the currency.

Credit: cautious stance on risky asset classes

We maintain a cautious stance on risky asset classes, as the monetary cycle has accelerated towards the hawkish side and inflation continues to rise. The increased tapering, QE tightening and rate hikes are a material change for credit markets. We expect greater dispersion, increased idiosyncratic risk and less supportive technicals with more supply.

Slight Underweight on EUR Investment Grade

We now hold a slight underweight position on € Investment Grade compared to our neutral view last month, though we maintain a preference for financials, where higher rates, decent fundamentals and less weak technicals are supportive. Spreads widened in January, but levels are still considered as stretched, though to a lesser extent. As inflationary pressures are high, we are at a turning point in monetary policy, and central banks are increasingly hawkish, leading to a decline in major support for IG markets. Moreover, the Chinese real estate sector and the COVID variant continue to create uncertainty, with the risk of slowing down the global growth trajectory. Dispersion and idiosyncratic risk are increasing amid issuer profiles, as companies are acting differently at this juncture - some are benefiting from pricing power, others are consolidating their industry ranking by making acquisitions, while others are suffering from growing costs. We see an increasing number of equity-friendly actions (dividends, share buy-backs etc.) that are likely to negatively impact credit markets. Selectivity through rigorous fundamental research will be key. Regarding technicals, a combination of less favourable net supply due to less support from the ECB (we only expect €35 billion of corporate asset purchases in 2022) and declining inflows into the IG asset class are also likely to put pressure on spreads.

Slight Underweight on EUR High Yield

Given lower monetary support and deteriorating fundamentals, we remain negative on the € High Yield asset class, as markets will remain volatile until the next ECB meeting. There is an attractive carry in the market, but specific risk is quite important (Softbank, Casino etc). Following the strong repricing of euro markets, some opportunities are emerging, essentially in the BB segment on shorter maturities, but selectivity is key. In the US, after the slight repricing of the Fed hiking cycle, the risk/reward is no longer attractive. Outflows are a risk, as hedging costs will rise and loans would be favoured. We continue to have a negative view on US HY markets.

Neutral on European Convertibles

Finally, we are moving to a neutral position on € Convertibles, which should benefit from positive dynamics such as the coordinated action from the Next Generation EU recovery package and earnings growth. However, we see increasing idiosyncratic risks, and we believe markets will remain volatile until clarifications from the next central bank meeting. Momentum is weak in the asset class, and we are waiting for a better time to re-enter, as we see valuations improving.