Amidst the turmoil, are central bank policies diverging? And what fixed income investment opportunities are emerging?

22 March 2022

This content is for professional investors only as defined by the MiFID.

By François Rimeu, Senior Strategist, La Française AM

Facing higher inflation risk than they initially thought, central bankers have decided to tighten their policy stance both in the US and in Europe, albeit at different speeds. The Federal Reserve (Fed) is clearly behind the curve right now with headline inflation at 7.9% (highest since January 1982), core inflation at 6.4% (highest since August 1982) and the unemployment rate at 3.8% (close to the all-time low at 3.5%) whereas Federal funds are still very low at 0.25-0.5% (Source: Bloomberg 22/03/2022). Given that inflation expectations are above target for the foreseeable future, the US Federal Reserve has no reason to stop its hiking cycle in the near future. Fed members have indeed been very vocal lately, signalling their will to remove accommodation quickly and to tighten the policy rate, if necessary, above neutral, which has led to financial markets pricing Fed funds at 3% in June 2023. 

The situation is both similar and different in the Eurozone. Similar because soaring energy costs have already pushed Eurozone inflation to a record high of 5.9% last month and inflation could hit 7% in the months ahead, well above the ECB’s 2% target. It is also quite different with a European economy, more reliant than the United States on commodity imports and which has experienced no clear wage inflation to date.
European Central Bank’s Lagarde has emphasized those differences recently, underlining, “Our two economies are in a different place in the economic cycle, even before the war in Ukraine” or “Our monetary policies won't be running on exactly the same rhythm”. We can assume a more gradual normalization in the Eurozone than in the US going forward, which is exactly what financial markets are currently pricing.

From now on, the directions of both the US and Eurozone bond markets going forward are likely to be determined by the overall thrust of the fiscal / monetary policy mix. If fiscal support proves to be disappointing, macro-economic indicators could also start to disappoint, especially with higher commodity prices overall hitting consumer demand. This is already what leading indicators are starting to show (OECD diffusion index, credit impulse...), but it could take months before we see any material negative impacts. The Covid crisis has led to unprecedented budget support from governments which in turn has led to very high saving rates for US and Eurozone consumers meaning that the negative effect coming from tighter monetary conditions and higher commodity prices could be delayed.

This environment is clearly not the most favourable for fixed income markets. Higher yields on governments bonds have a negative impact on the whole fixed income spectrum, meaning that investment grade bonds, high yield bonds and emerging market bonds are all suffering from this massive repricing. One of the few options has been the TIPS market (Treasury Inflation-Protected Securities) but even there, the total return is negative YTD (22/03/2022, Bloomberg).

Going forward, we expect central banks to keep on accelerating their hiking plans, which should lead to flatter yield curves (or inverted yield curves, depending on the market), especially in the US but also in Europe. A flat yield curve is often associated with a high probability of recession, which makes sense on a theoretical basis as it signals the intention of central bankers to tighten rates above neutral, which would hurt demand over time. The question here is how long would it take? Normally a Fed tightening cycle is at the early stages quite risk-on. Later, markets worry about policy tightening driving a growth slowdown. But at present, policy tightening is urgent and investors are already preoccupied by growth slowdown prospects.
In the short term, and as long as the Fed continues to push for tighter monetary conditions, we find it difficult to have a very constructive view on credit markets and emerging markets. We prefer the longer part of the yield curve vs the shorter part. Lastly, we are also negative on long-term inflation expectations as the ultimate goal of the Fed is to push them lower. 

Disclaimer
This commentary is intended for non-professional investors within the meaning of MiFID II. It is provided for informational and educational purposes only and is not intended to serve as a forecast, research product or investment advice and should not be construed as such. It may not constitute investment advice or an offer, invitation or recommendation to invest in particular investments or to adopt any investment strategy. Past performance is not indicative of future performance. The opinions expressed by La Française Group are based on current market conditions and are subject to change without notice. These opinions may differ from those of other investment professionals. Published by La Française AM Finance Services, head office located at 128 boulevard Raspail, 75006 Paris, France, a company regulated by the Autorité de Contrôle Prudentiel as an investment services provider, no. 18673 X, a subsidiary of La Française. La Française Asset Management was approved by the AMF under no. GP97076 on 1 July 1997.

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