Heading into 2022, volatility in global bond markets is rising, with 25bps one-day moves in front-end Eurodollar contracts, a sharp and chaotic rise in USDTRY and China high yield spreads already wider than the levels reached in US high yield in 2008. While 10-year Treasury yields are no higher than ten months ago, if you look more broadly across global fixed income, multiple sigma events are back.
In September, in our outlook entitled “Tunnel Vision”, we discussed the fixed income market’s narrow fixation on inflation, the popularity of bear-steepener positions in US Treasuries and the consensus overweight in credit. We pointed to Harvard and Cornell University psychologists Christopher Chabris and Daniel Simons who showed in their “Invisible gorilla experiment” the role of selective attention, in which humans can cognitively become focused solely on one subject at the expense of noticing and considering others.
Since then, we think fixed income markets have started to broaden their horizons. With the first lockdowns in central and northern European countries in mid-November, an aggressive flattening of the Treasury curve and evidence of short covering in longer-maturity tenors, the steepener is arguably no longer the main pain trade. The US long bond now trades close to the forwards that were priced in January this year. Yet in the short term, the process seems incomplete: the size of recent shock declines in global bond yields on news of the omicron variant suggests bond investors are still not positioned where they need to be relative to their liabilities.
Heading into 2022, what might markets be missing? We see three topics. First, is the next chapter in China credit. In September, we cited the risk of an acceleration in volatility in the China high yield property market. Now, with widespread real estate defaults priced and economic slowdown underway, the question is how contagion might spread to smaller and medium-sized Chinese banks and the local-government sector. After all, for the banks, for every borrower there is a lender. For local governments, land sales have now halved. Second, we think most market participants need to reassess their assumptions on Covid. Third, we note a myriad of political and geopolitical risks, including the US debt ceiling (again), Article 16 questions between the UK and the EU, and a broad range of flashpoints along the EU’s eastern front, from Polish sovereignty matters, to Belarus geopolitics, Russia-Ukraine tensions and the clash between monetary policy and politics in Turkey. Of this third category, only the debt ceiling could give a surprise of truly global significance. Nevertheless, regional volatility is possible and should many of these events turn sour at the same time, that could coalesce into a risk-off tone.
These three factors should be viewed alongside (and not in place of) the inflation debate, which rumbles on. Since our last quarterly, used-car prices have headed higher in the US, and European natural gas prices remain stubbornly high amid a hydrocarbon transition that might not have planned fully for geopolitical contingencies. Supply chain disruptions continue, and wages in the lowest-income quartile are still rising quickly in the US as labor market mismatches persist. Rental inflation is now starting to rise too. In 2022, the progress on all these variables will influence central bank attempts to roll back pandemic-easing measures. Overall, we think the peak has just been reached for Eurozone inflation, while the US looks stickier in H1 2022. We expect an eventual moderation globally in H2, as base effects and supply chain disruptions ease, but to a higher inflation run rate than the past ten-year average. Still, the pricing of inflation expectations looks to be getting ahead of itself.
On the virus, with the discovery of the latest variant by scientists in South Africa, events are moving quickly. As of 26 November this was labelled Nu. Within 24 hours it had become omicron (with the World Health Organization skipping out the fourteenth letter of the Greek alphabet). Nomenclature aside, we think this illustrates the importance of taking a more dynamic view. After all, omicron will not be the last mutation, and is therefore also unlikely to be the last variant of concern (VOC). It would be presumptuous to rule out the evolution of pi, rho and sigma in due course, and we may well be back to a new alpha (or equivalent) once omega is passed and the 24 Greek letters (minus those not used) have been ascribed. These new future mutations (which have not yet occurred, but which we can reasonably expect) may or may not threaten vaccine efficacy or change transmissibility assumptions. But if markets do not consider how future scenarios might evolve and how weighted scenario-based risk premia should then be priced, multiple sigma events (such as those of late November) will recur. Taking the approach of the Tel Aviv University paper we referenced last quarter, our base case is that the world population will need to achieve sufficient levels of mucosal immunity for the virus to diminish in market importance. This isn’t just extrapolation, rather the blending of scientific findings into the forecast.
In sum, we note several multiple sigma events across fixed income markets. We think the way to approach this environment is to keep a broad perspective and look for asymmetry. That includes a long-duration stance in China given the potential requirement for substantial policy easing. Conversely, we think the long end of the JGB market is most asymmetrically exposed to higher yields, should the higher-inflation regime prevail. In European sovereign spreads, political events first in Italy and then in France come into focus in H1 2022, suggesting underweight positions versus other European spread products, albeit in the context of ongoing ECB purchases. In Treasuries and Bunds, we still like flatteners, although we think the value in the US has now shifted to 2s5s.
In credit, we note spreads in EUR and USD IG and HY have just begun to widen, and many sell-side strategists are beginning to come round to a more cautious point of view. The buyside is still largely overweight credit, so a potential mindset shift looks likely. Shifting a large real money book tends to have a larger market impact than the stroke of a strategist’s pen, so we can expect a market impact here.
In Asian credit, the potential spillover to local government bonds and small and medium-sized banks is the key question. IG China financial spreads are highly asymmetric here, a very different proposition to China high yield spreads, which already price in deep sectoral recession and widespread defaults. This oddly compartmentalized current market pricing makes the outlook for China IG financials highly asymmetric, and ripe for a bearish portfolio stance. Emerging markets appear vulnerable either to a stronger dollar scenario, should inflation fears resume, or to the China hard-landing scenario.