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One of the main challenges financial markets have to deal with over 2022 consists in navigating DM central bank exit strategies. Reading the remarks made by Chair Powell to the Committee on Financial Services (US House) and Committee on Banking, Housing and Urban Affairs (US Senate), it becomes evident that the FED Board has retired the notion of ‘transitory’ inflation. With the continued healing of the US labour market in mind, the FED decided to tighten its risk management policy. If anything, the Omicron variant might extend this episode of intense supply chain disruption and ensuing inflation pressures as aggregate demand remains robust. People will get discouraged in looking for a job or expect more government support in the form of temporary benefits.
The FED realizes that QE tapering will need to accelerate as second-round effects, impact of rising prices on wage negotiation power, become visible across sectors. A base case scenario gains traction that sees an end to QE by Easter and a first policy rate hike over the June 15, 2022 FOMC meeting. FED fund futures price a total of 2.5 hikes by the end of 2022.
Bond markets translate the FED’s dedication and zeal in cementing its price stability objective through a surprisingly forceful US Treasury yield curve flattening. The FED does not want to run behind the curve. The FED does not want to get cornered. I’m effectively positively surprised: an aggressive first sprint of rate hikes just might do the trick in stifling speculative behaviour before it’s too late. Financial markets should be assured that DM central banks will avoid getting behind the curve at all cost. Risk taking and risk aversion is seeking a right balance. That balance becomes visible at the longer end of yield curves. US bond and equity markets translate such a steady state by putting 30-year US risk-free rates between 1.50% and 2.00%. For corporate America, that translates to long-term funding levels that are 75bp to 125bp above those levels depending on the credit quality of balance sheets. ESG leaders profit from greenium or tighter spreads for a company’s green bonds versus their ‘non-green’, traditional bond curve. Long-term corporate funding levels between 2.25% and 3.25% offer investors the opportunity, with inflation at the 2% target, to lock in a positive number in real capital growth.
The ECB will not miss out on the momentum offered by the colleagues in Washington DC. The EU Next Generation fiscal support strategy is lifting real growth expectations markedly across France and Italy for this year and next. The EU fiscal impulse is underestimated. The ECB should embrace a return-to-positive-policy-rates agenda over the next 2 years. Expect economic projections within the ECB base case scenario to adjust towards a higher longer-term inflation estimate. Do not downplay overdue second-round inflation effects. Why should the ECB president downplay inflation reaching longer-term objectives? Still, Ms Lagarde used the disinflation narrative over the past weeks… “We still see inflation moderating in the next year, but it will take longer to decline than originally expected”.
2023 will shape up as the year for the ECB to mimic a ‘FED style 2022’ policy rate tightening sprint. The ECB will not hesitate to get out of this uncomfortable negative interest rate policy conundrum. Risk-taking behaviour by systemic banks is not a recipe that leads to financial stability. Especially banks with a high client depository base reach for yield. The ECB risk management policy should not foster such behaviour.
Expect the German bund curve to adjust accordingly over 2022 alongside an intra-EMU spread convergence acceleration. Italian and French presidential election uncertainty over January and April 2022 respectively might put a temporary brake on a convergence outcome. In the meantime, rating agencies still play catch up by notching up outlooks and ratings of periphery EMU markets.
Last Friday, Fitch adjusted the Italian Long-Term Issuer Default rating to BBB with Stable outlook from BBB-. Fitch citing high vaccination rates, an increase in public and private spending and high resilience to global supply disruptions. Italy is boasting one of the highest EU growth rates over 2021 at 6.3% and 2022 estimates score above-average expecting a 4.6% expansion rate. Investors get a second opportunity in the same number of months to lock in 10-year Bund-BTP spreads above 130bp. A debt to GDP level of 153.5% end of 2021 should not keep investors away from the attractive BTP rate levels on offer. A revisit sub 100bp is in the cards the moment the market endorses Draghi to remain Prime Minister till parliamentary elections at the latest on June 1, 2023.
Market participants get free trials on yield curve volatility. Average yield volatility is muted. Over-aggressive monetary reactions functions, from New Zealand to Czech central banks, up to hesitating central banks the likes of the Bank of England, bond markets offer plenty of curve positioning opportunities. They have one trait in common: the yield curve disruption is linear with the inversion intensity. The more aggressive or fast the pace of policy rate normalisation, the more extreme the inversion might become. Also beware of the negative impact on total returns for investors mainly positioned at the shorter end of yield curves. One locks in poor diversification and capital preservation quality the moment risk assets correct.
Central bank exit strategies should not be feared but taken as an opportunity to solidify balanced portfolio construction. Nothing is what it seems. Watch respective guidance and actual normalisation pace as the leading DM central bankers takes us out of an era of negative and zero policy rates.