None of the market swings add up to a rout: the fixed income sell-off velocity is relatively broad and orderly. This makes it more likely to be supported than a brief overreaction. It’s the bond market’s job to send out inflation warnings, but the function has been stifled by all the QE bond buying over the past decade.
The current uptrend has been driven by real yields – meaning nominal yields minus inflation – as there is a fundamental rethink in the magnitude of price gains over the next few years. TIPS, ie 10-year US Treasury bills protected against inflation, have already gained 60 basis points this year. This shows that the market believes that central banks have intervened too late to control inflation. Through Tuesday, German Bund yields have risen for 11 consecutive sessions, gaining 35 basis points, the worst stretch since unification in 1990.
None of us have a crystal ball, including central bankers. After all, it was their stimulus packages – amid chip, logistics and energy price shocks – that allowed inflation expectations to take hold. The Federal Reserve – which is not done with the stimulus – is doing a good job of fooling the markets into believing that it will get inflation under control. Many market commentators pulled an overtly hawkish message out of the latest FOMC press conference and statement, but the key word used by Chairman Jerome Powell was “agile” – which surely means reacting to data shocks both ways. , not just a series of hikes.
As the worst of the inflation spurt is likely past, future bond yields (and therefore stocks) will likely react to the strength of the economy rather than historical inflation gauges. Pay attention to forward growth indicators and how the Fed is reacting to them.
It makes sense that credit spreads – the premium companies pay over government benchmarks – started from a very low level. If yields rise overall, the bond space will experience asset reallocation. For example, peripheral European sovereign credits underperformed investment grade companies because that is where there was a necessary repricing of risk.
In Europe, investment-grade spreads are close to the 10-year average – a period that covers the Eurozone debt crisis, the commodity jitters of 2016, the Italian crisis of 2018 and the pandemic itself. . The rise was relatively strong, with February already one of the worst months for spread widening in years: 98% of the Euro Investment Grade index is wider this year. Part of that may be an overreaction to a perceived sudden change in the European Central Bank’s thinking on continuing the stimulus.
On the positive side, global default rates – admittedly a lagging indicator – show no signs of picking up. That’s largely because all that fiscal stimulus means there’s little chance of a recession. Companies’ access to finance in recent years has also been abundant: most have been drinking long and hard from the well and are being financed at extremely low rates for several years. According to analysts at JPMorgan Chase & Co., US corporate spreads should benefit from foreign buyers attracted by the burning US economy.
Nonetheless, overall, bonds are bound to underperform, as underlying government yields are adjusted to the post-pandemic economic and inflationary recovery. Coverage of extreme risks becomes more necessary. Credit remains a relatively safe space. The supply of new debt may moderate, acting as a natural balance until more attractive yields attract investors. For now at least, the size of the books on European and British sovereign deals remains very healthy, with Spain’s new 30-year contract on Wednesday seeing orders nearly 10 times the 7 billion euros (8 billion dollars) raised.
The spread from Italy to Germany may be the widest since the summer of 2020, but this is likely more of an investment opportunity than a warning signal. The fundamental backdrop for Europe’s third-largest economy is much stronger than it was during the May 2018 sovereign crisis, which saw 10-year BTP yields double in a short time to over 3.5. %. They have risen 120 basis points since the summer but are still only halfway to the extremes of 2018. It helps that the political setback over the presidency is resolved for now: Mario Draghi remains prime minister; there is no Italian crisis.
The ECB is ready to buy the entire €60 billion net supply that Italy is issuing this year. With these higher yields, Japanese buyers may be tempted to diversify away from the still negative yielding German Bunds, a trend that many others are continuing.
Bonds are now somewhat akin to stocks, becoming more of a stock-picking market. There are bargains for those engaging in the asset class. But it will be a big job until inflation subsides or growth falters.
More from this writer and others on Bloomberg Opinion:
Bank of England wakes up sharply to inflation risks: Marcus Ashworth
Fed treats New York and Los Angeles another setback: Conor Sen
A big change is underway. It’s not just a rate hike: Daniel Moss
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in banking, most recently as Chief Market Strategist at Haitong Securities in London.