Data on inflation in the US and eurozone continues to surprise to the upside, roiling bond markets. Expectations for US and European monetary policy in 2022/2023 have repriced to integrate more hawkish policy. The extent to which this will be realised depends on how much inflation rises and growth slows from here.
Equity markets continue to show considerable resilience despite a marking down of global economic growth forecasts, rising commodity prices and new evidence of the strength of inflationary pressures. After the initial global stock market sell-off, the MSCI All Country World Index has now risen back above its pre-war level, while the VIX volatility index — an indicator of expected market volatility — has dropped back below its long-term average.
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March is on track to be the worst month for US Treasuries since July 2003. In March the Bloomberg US Treasury Aggregate index returned negative 3.5% through 30/03/2022 (negative 5.6% year-to-date).
Short-dated US Treasury notes have withstood the worst of the sell-off as markets price in a significant tightening of monetary policy by the US Federal Reserve to contain inflation.
Market expectations for fed funds have shifted substantially to price more than 200bp of Fed rate hikes by the end of 2022, in addition to the 25bp hike earlier this month. If realised this would take fed funds close to the median Federal Open Markets Committee (FOMC) long run DOT by the end of 2022.
Yields of two-year US Treasury notes this week rose above those of the 10-year US Treasury for the first time since August 2019, inverting a portion of the yield curve. Two-year yields rose as high as 2.45%, the highest level since March 2019. They have since fallen back to 2.31% with the yield of the 10-year US Treasury bond now at 2.35% (see Exhibits 1 and 2 for changes in US and German 2-year and 10-year yields).
Eurozone bond returns also suffer
Markets are now pricing several rate hikes from the ECB to take policy rates back up to zero by the end of 2022. Data published this week showed German inflation rose to its highest rate for 40 years. A year-on-year rise of 39.5% in energy prices was the main driver behind a higher-than-expected increase in Germany’s harmonised index of consumer prices (HICP) to 7.6% year-on-year. This data came hours after the German government took the first formal step towards rationing gas supplies. The German government is taking precautionary measures should there be a halt in gas deliveries from Russia because of a dispute over payments.
Data for overall eurozone price growth in March is due on 2 April. The omens are not good. High frequency data suggests that the monthly increase in eurozone petrol prices could be the greatest on record and data published yesterday showed annual inflation in Spain rising to 9.8% in March, the highest level since 1985. It is therefore likely that eurozone inflation data will deliver a ninth consecutive monthly rise exceeding consensus expectations and probably set a new record well above 6% on an annual basis, after 5.9% in February.
In response to the inflation news the yield of the benchmark German 10-year bond rose this week to 0.70%, a four-year high. Yields of the 2-year German government bond rose above zero for the first time since 2014 (they began the year at negative 50bp). Returns in March for the Bloomberg Euro Aggregate Treasury index are negative 3.07% through 30/03/22 and negative 5.98% for the year-to-date.
What happens next?
Our fixed income team have had a longstanding view that inflationary pressures would lead the ECB and the Federal Reserve in particular to hike rates faster and further than priced by the market. The magnitude of the rise in rates this month is such that bond yields have reached levels that are at or close to where we might have anticipated they would end the year. We have therefore taken some profits on our underweight duration positions but remain underweight interest rate risk overall.
The question now is whether we agree with current market pricing, which continues to imply the current spike in inflation and rates will eventually subside, with the previous paradigm of “secular stagnation” reasserting itself. The fed funds futures curve for example, currently implies rate increases will stop below 3% by mid-2023 with policy weakening thereafter.
The answer to this question depends mainly on how economic growth holds up and whether the inflation shock has further to run. In a recent interim economic outlook the OECD estimates that in the wake of the Ukraine conflict, world output will be 1.1% below what it would otherwise have been. The impact on the US is estimated at only 0.9%, but on the eurozone it will be 1.4%. The comparable impact on inflation would be +2.5% for the world, +2% for the eurozone and +1.4% for the US. Increased prices of energy and food will reduce the real incomes of consumers by far more than these gross domestic product losses suggest.
The German IFO Business Climate Index for March saw the largest decline in history, even exceeding the decline from Covid-19. This highlights the risk of a technical recession in Germany, one of the economies in the eurozone most vulnerable to the Russia-Ukraine conflict.
We continue to believe the ECB will remain on a path of policy normalisation. However, the impact of the Russia-Ukraine conflict on eurozone growth, set against the more balanced risks to inflation over the medium-term, increase uncertainty on the timing of ECB rate hikes. Indeed, wage growth in the eurozone remains subdued and recent developments suggest that unions are moderating near-term wage demands in light of the conflict.
In a speech on 30 March, ECB President Christine Lagarde summed up the outlook as follows:
“Europe is entering a difficult phase. We will face, in the short term, higher inflation and slower growth. There is considerable uncertainty about how large these effects will be and how long they will last for. The longer the war lasts, the greater the costs are likely to be.”