Vontobel's Head of the Fixed Income Boutique argues market has 'front-loaded the fear' of tapering and interest-rate expectations
With record-high inflation running amok across the world, the balance of probability is tilting decisively towards a scenario of central banks embarking on rate-hiking campaigns in developed economies. Fixed-income investors are likely digesting that information with a certain degree of anxiety – but there could be a silver lining.
“Definitely, inflation and potential rate hikes by central banks in the developed world are valid reasons to feel uncomfortable in fixed income as a whole, emerging markets included,” said Simon Lue-Fong, Head of the Fixed Income Boutique at Vontobel. “But I do think that the market has, in a way, front-loaded the fear.”
According to Lue-Fong, fixed-income markets are pricing in five interest-rate hikes this year from the Federal Reserve, and two more hikes next year. They’ve also priced in expectations that tapering will be over by the end of March, and that it will be followed by quantitative tightening within the first half of this year. That has pushed yields on the 10-year U.S. Treasury to as high as 180 basis points, compared to 150 bps at the end of 2021; even before that point, Lue-Fong says yields had been rising.
“That has caused pain due to negative returns, but I do think quite a bit of negativity has been priced in already,” he says.
The Fixed Income Boutique also expects inflation to begin to roll over by the end of the first quarter. Aside from anticipating that base effects will begin to take hold, Lue-Fong is looking at the Prices Paid Index, which he says has tended to be a leading indicator of inflation as there’s a high correlation between the two.
He says that while prices paid have been dropping, inflation hasn’t inflected toward the downside yet. To him and others at the Fixed Income Boutique, that means the market has correctly priced the trajectory of interest rates increasing as central banks act to tame inflation. A reading of the Federal Reserve’s dot plot, he says, shows that what the central bank is seeing broadly is in line with what the market has projected.
“There's probably going to be less surprises, and the markets don’t have to be as volatile as they’ve been,” he says.
As inflation starts to decline in earnest and the market feels more comfortable, he believes that growth will take the spotlight. If it seems like it’s slowing or decelerating to pre-COVID rates, when growth was largely below its potential in most places around the world, bond markets will rally. But if growth appears very strong, the market may have to assess and contemplate whether central banks will want to try and temper that while they can.
A movement towards growth would be beneficial for emerging markets, as they tend to leverage off the growth of more advanced economies. With respect to inflation, he says emerging-market central banks were already raising their base rates last year because they don’t have the credibility enjoyed by the likes of the Fed or the Bank of Canada. That means emerging economies will probably see base effects kick in and inflation rates start to fall soon.
Also notable, Lue-Fong says, is the surprising strength of the U.S. dollar last year. As EM central banks raised their base rates to cope with strong inflation in their respective economies, EM local-rate debt got sold off. Because a strong greenback tends to be a headwind against EM currencies, that created an additional layer of weakness.
“You basically had two engines that were in a way taking you down,” he says. “You had weak FX return, and you had weak returns on local-rate bonds.”
It’s only the early weeks of 2022, but Lue-Fong says so far EM local-rate debt and the FX have sustained remarkably little damage; at the time of the interview with WP, local-rate debt from EM countries was outperforming both EM sovereign debt and EM corporate debt in dollars. The message he’s getting is that EM local debt has generally already repriced from where it was in 2021, when it dipped by a painful 8.75%.
He says EM dollar debt, both on the corporate and the sovereign side, have been hurt by their relatively high sensitivity to Treasurys. As Treasury yields moved higher, that took some of the shine away from the spread offered by EM dollar-debt. But because a lot of the negativity has been priced in, Lue-Fong believes that negative impact will start to fall off.
“We think that as the market starts to calm down, you'll start to see spreads outperform,” he said. “They'll tighten, and therefore you will get capital gains through the spread market.”
