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Over the past week, investors have been confronted with a catch-22 situation. A catch-22 is defined as follows: “a dilemma or difficult circumstance from which there is no escape because of mutually conflicting or dependent conditions”. Central banks are confronted with but at the same time inflict a catch-22 onto financial markets. Valuations across public-, and over a short period of time, private-assets as well, are adjusting from historically high levels. Since mid-December rate markets became unhinged. Especially short, intermediate and to a lesser extent long-term interest rates received a substantial lift. The rate adjustment accelerated as the FED gave a confirmative nod to markets when pricing 5 hikes over 2022. The rate adjustment received another impulse because of increased impatience from the Bank of England, raising the bank rate to 0.50%. The ECB joined the party, informing participants that the ECB December meeting would be a ‘live’ event announcing lift-off. Are financial markets strong enough when DM central banks start to tighten policy almost at the same time? A complex question that sets us up for complex answers. Let’s start with the positives and end with the main tail risk.
The first positive is related to the yield curve behaviour. The overarching tendency is that investors are confronted with a bear-flattening process. The nature of the process is an aggressive one. That also explains why investors who sought shelter in an EMU Government 3 to 5 year index looked at a YtD result of -1.41% on February 3. The broad EMU government index sits at -2.08%. The mainstream European corporate bond index with an interest rate sensitivity of a modest 5.25% posts a retreat of -1.97%. Global bond indices range between -2.30% and -2.65%. All the above results are worse at the time of reading as the sell-off on February 4 has not been included.
Interestingly, as curves bear flatten, the forward rates on 10-year bonds add very little based on the expectation that short-term policy rates will rise sharply over the next year or two. Flat curve conditions reflect a central bank in full control. It reflects their ability to steer the monetary system towards a state that contains inflation expectations, limits speculative behaviour but also confirms their credibility and independence.
The FED might have a flat curve around 2.00% in mind. Today, the spot curve is still steep. The 10-year rate 10-years forward sits at 2.70% or about 40bp above the level witnessed on average since the GFC for 10-year rates (see later).
The Bank of England will settle for a curve stuck at 1.5%. The ECB EU ‘yield curve’ might reach a healthy equilibrium around 0.75% to 1.00%. Given multiple EMU members and a lingering presence of credit risk, the complexity of reaching stable conditions without ECB QE support is tantalising.
The second positive is the fact that the army of market commentators predicting higher inflation prints, from current lofty levels, is on the rise. The main argument is a circular one as the current spike in rates is taken as proof of what is to come. By now, however, having lived in a highly fluid corona-dominated global pandemic over the past two years, it should be clear that short-term predictions carry little value. Even if month-on-month US headline CPI figures rise by 25bp over the next 5 months, we will still have YoY US headline CPI dropping towards 4% by summer…base-and seasonality effects will play out. The Russia-Ukraine stand-off should abate by March-April to arrest the in-favour-of-oil against gas substitution forces. Russia requires a predictable and stable natural gas price formation over time. The whole inflation debate centers around goods and energy inflation. These components have exhibited high volatility. The long-term ESG argument is not that strong as a renewed long-term pro-nuclear energy argument might stage a prominent come-back and alleviate fossil fuel pressure points.
The third positive is a technical one. Investors should embrace a sharp and (painful) sharp drawdown in the fixed income component within their diversified portfolio. A sharp spike in rates, alongside modestly higher credit spreads, inflict short-term pain as an unusual drawdown episode is testing investor nerves. In % terms, the level of negative yielding public bonds outstanding, globally, dropped towards 9%. A level that was present at the end of 2015, before the ECB joined other main central banks in a synchronised QE asset purchase program. Negative yielding bonds made a top with a reading just above 30% end of August 2019. We conclude that the monetary and fiscal impulse led to a drop by more than 2/3 of outstanding negative yielding bonds during this terrible COVID-19 episode. Reflation has worked.
It represents an opportunity for bond investors that believe that the long-term, aggregate, demographic, technological and productivity drivers still point to modest potential growth over the next decades. This school of investors adheres to a worldview characterised by long-term DM rates below 3%. Terminal policy rates at 0.75% (ECB) – 1.50% (BoE) – 2.00% (FED) – 2.25% (RBA) – 2.50% (RBNZ). These terminal rates should enable inflation expectations to remain anchored around 2.00%. Debt sustainability problems are avoided. Financial market volatility is contained.
The main tail risk represents the other side of the medal. It causes unease and defensive positioning for investors that adhere to a school that fears a return to pre-GFC 2008-2009 interest rate levels. Over the 20-year financial market goldilocks era between 1988 and 2008, average US headline CPI printed at 3.1%. US 10-year rates averaged 5.93% over that 20-year period. It was a steady bull market for fixed income, with 10-year rates at 3.96% over July 2008. The Lehman drama changed the landscape. Enter QE. Between mid-2008 and today headline CPI shows a 1.9% average figure…for an average 10-year US Treasury rate at 2.29%! Can we be stand at the cusp where central banks deny future use of the QE policy instrument? I reckon the answer requires a firm YES to attach a high probability of average 10-year rates jumping towards 4.00% over the next decade. That would result from a sticky inflation condition at a 3.00% level as fiscal support, supply frictions and deglobalisation play out. The above scenario requires populist policy making. Preferring inflationary and stand-still policies above responsible fiscal, redistributive and productivity-enhancing economic policies. Debt sustainability problems pop-up over time. Financial market volatility spirals out of hand.
2022 negative performances across asset classes amplify the noise. Participants panic. I looked back at the motion in long-term rates over 1994-1995: a sharp bear bond episode followed by a sharp bull bond episode. As if both were married…in a mechanical fashion. OK. We had a jump of about 40bp in 10-year US rates as well as 10-year German bund rates over the past 5 weeks. The intensity reminds me of 1994. A copy paste would take us to 3.75% in US 10-year rates and 1.90% in 10-year bunds. Such an outcome is an extreme tail risk. The catch-22 would also become unbearable for investors as financial markets would go through a stress test never witnessed over the past 50 years. Be careful what you wish for.