The new year brought renewed tensions and volatility to markets, triggered by the rapid shift in narrative from central banks. Steve Ellis, CIO, Fixed Income, Fidelity International comments on how strong inflationary pressures, which had been strengthening for most of 2021, have brought policy focus on the need for immediate and significant tightening, and how this might play out in the year ahead.
“All major central banks have, in the space of a few weeks, done some significant pivots in their messaging. Markets have moved swiftly in repricing policy expectations, with some dramatic moves at the front end of most yield curves, higher yields and flatter curves.
“The outlook for central banks is not an easy one. Having been caught behind the curve they are now trying to catch up at a time when the risks of policy errors have risen. Following the pivots that we have seen, the hurdle to reverse course once more is now extremely high. Markets and investors will have to be ready for volatility and uncertainty to come.
“In the near-term, central banks are unlikely to push back against market expectations of policy tightening, effectively letting markets do the tightening of financial conditions on their behalf. Data will be key, particularly in the second half of the year, when growth is expected to slow following the 2021 rebound and inflation to come off as temporary drivers fade, and base effects come into play.”
Fed: Our base case for three to four hikes this year
“In the US, markets have now priced in around six rate hikes for the Fed, effectively one at each of the 2022 meetings, with the pace of quantitative tightening yet to be determined. We expect the balance sheet runoff to start earlier than in the previous episode – after one or two hikes – and to be steeper, at least initially. Assuming the ratio of quantitative easing (QE) to quantitative tightening (QT) pace is held the same as before, the maximum runoff cap is likely to be about $90-$100bn per month for both Treasuries and mortgage-backed securities (MBS), which is double the maximum cap seen in the last cycle.
“What the market is currently pricing though appears to be excessive in terms of rate hikes and balance sheet reduction that the Fed can achieve this year. In our view, the best course of action for the Fed, is either do a few quick hikes, and then pause whilst QT gets underway, or to follow a slow hiking path whilst concurrently implementing QT.
“Our base case is for three to four rate hikes this year rather than the six currently implied by the market, and for real rates to remain the barometer for both the Fed and risky assets. With the debt burden so much higher after the pandemic, real rates have to remain in negative territory for a long period of time for the debt trajectory to stabilise at sustainable levels. Indeed, we believe maintaining negative real rates is currently the implicit policy objective of all major central banks. Looking at US Treasuries against this backdrop, we currently have an underweight stance, mostly driven by our quant models, but would look to add to our duration exposure should we see yields rising further from current levels.”
ECB: All eyes on March meeting
“For the European Central Bank (ECB), the focus is squarely on the March meeting, where the new set of Staff Projections will be shared, and where we expect more clarity on the plans for the Asset Purchase Programme (APP). The ECB outlined its plan for net asset purchases to the end of the year, meaning the first rate hike is only possible in early 2023, in-line with the sequencing constraint.
“The ECB might well accelerate the tapering timeline to cease net asset purchases before the end of 2022 to meet conditions for a rate hike earlier if required. While it is possible the APP will now end in June, we are more inclined to think the quantitative easing exit will be pushed to Q3 or Q4.
“Like for the Fed, markets have priced in a very aggressive policy path for the ECB. Current market prices see a +50 basis points depo rate in 2 years’ time, which is the terminal rate in our view, which should anchor yields further down the curve. While there is a chance for 10-year Bund yields to rise further still, we see the top of the new range at around 20 basis points. We have added to core European duration on a discretionary basis as a result following the latest moves. On QE, with financial conditions at very easy levels and growth likely to pick up from the soft path in Q1, the market will continue to expect a much swifter end to the ECB’s Asset Purchase Programme than previously envisaged. Peripheral spreads will likely remain under pressure as a result.”