Last quarter, in ‘Pricing sigma’, we wrote that multiple sigma events are back in fixed income. The first few months of 2022 have accelerated this, with US 2-year yields up over 140 bps so far this year, EUR swap spreads approaching Eurozone crisis levels and the China offshore high yield market seeing an OAS of more than 3000 bps. After nearly a year and a half of an expensive and generally dull landscape in fixed income, with opportunities mainly on the short side, value is beginning to return.
At our last Global Macro Quarterly Outlook, we thought market participants might be overlooking three themes in 2022: the breadth of deterioration in China real estate credit, Covid-19 trends and geopolitics. We noted “a broad range of flashpoints along the EU’s eastern front (…) from Polish sovereignty matters, to Belarus geopolitics, Russia-Ukraine tensions…”. Into Q2 2022, all three concerns remain, although the focus of Covid trends has shifted to the People’s Republic of China, and the world’s attention is now fully centered on geopolitics.
Looking into Q2, we should acknowledge some uncertainties. The oil price could trade in the USD 80s or above USD 130: we have seen both in the past 30 days alone. Furthermore, the scale and coordination of the EU fiscal response in energy and defense is unclear (although the fiscal architecture is also potentially at stake; as 2020 showed, Federalist Eurozone politicians tend to make structurally cohesive steps during crises).
The full effects of Russia’s unplugging from the global financial system are arguably still not yet known. Deciphering the next military calculations that will take place from inside the Kremlin are best left to academics, but decisions taken here may cast a long economic shadow.
Before the Russian invasion of Ukraine, inflation was already rising, and markets were pricing in more hawkish central bank profiles – even for the ECB. It’s worth remembering the US 2-year yield was at 0.73% on 31 December 2021; it has just risen to over 2.15%. Since military action began, the subsequent rise in oil to well over USD 100 and the further sharp flattening of the US yield curve have led economists globally to raise their inflation targets, to extend the forecast period of higher inflation and to cut growth.
The Fed, for example, have slashed their 2022 growth forecasts from 4% to 2.8%. Their inflation forecast is the mirror image, having been revised up sharply from 2.6% to 4.3%. Coming into 2022, expectations were for substantially above-trend growth. Indeed, 2.8% would compare well with the post-2008 growth trend, and a modestly above-trend outcome could still be delivered amid reopening and order backlogs – if there were to be an early conclusion to the Russia-Ukraine war. But we note financial markets often tend to underestimate the length of shocks of this nature, and there are evident and growing risks. The debate is rapidly shifting to what probability to place on a recession over the medium term. We note a number of senior economists already calling for recession within the next year or two.
The growth-inflation mix that central bankers now face is the opposite of the high-growth, low-inflation paradigm of the 1990s – when Russia and Eastern Europe were welcomed back into the west’s financial and economic networks. Now, with inflation soaring above central bank targets, the question for policymakers is who will tighten by how much and when.
In chess, there is a term ‘zugzwang’, which describes a situation in which the obligation to make a move may lead to a serious, often decisive, disadvantage. For central banks, if they do not tighten, expectations for higher inflation could become embedded, leading to wild misses of mandate targets and undesirable spirals. Should they overtighten, however, the risk of recession looms. Don’t forget that the Fed’s delayed decision to taper QE in 2021, will this year bring a triple tightening of tapering, hiking and balance sheet contraction. All this was due in any case, before the recent commodity price spike.
…and yield curve inversion
For bond markets, this has meant a continuation of the yield curve flattening trend we wrote about through much of the past nine months. And sharply so. The US 2s10s spread (now below 20 bps) stands at less than a quarter of what it was on 1 January 2022 (above 80 bps). To understand what might transpire from here, we recommend starting in Prague. The Czech local yield curve is usually not top of most global bond investors’ monitoring list. But this cycle, it was the first to invert. Central and Eastern Europe (CEE) central banks have hiked rates aggressively in response to the same inflation pressures we are all experiencing. The CZGB yield curve has tipped over as the market’s estimation of the neutral (or r*) level of rates has been eclipsed by the Czech National Bank’s rate hike activity and the prospect of further near-term hikes.
Why should we care? Because, since then, the Czech trend has spread to bond markets as diverse as Poland, South Korea swaps and UK Sonia. The US yield curve 12 months forward is now almost completely flat with almost all tenors trading close to 2.60%. In fact, with the US 1yr1yr forward the highest point on the curve, forward curve inversion has already begun.
Flat or inverted yield curves do not always mean recessions (see 1994 and 1998, for instance, when we had emerging market (EM) crises, but developed market (DM) economies escaped recession). There is also often a time lag, such that recessions may occur some time after curve inversions, particularly if the actual real borrowing costs faced by private sector agents have yet to rise materially.
It is also mathematically likely that, in markets with low r*s, recessions can occur without yield curves inverting at all: Japan has had seven recessions since its curve last inverted, and Germany has had three. So it is neither a sufficient prerequisite, nor the automatic cause of an outcome. Yet the historic track record (and the reasons behind it) of yield curves, should not be dismissed.
Critically, from current levels of inflation, the Fed has never tightened just enough to make inflation come back down to target without causing a recession. Commodity strategists already talk of ‘demand destruction’ as the central scenario for wheat and energy prices to come back down in due course. For the likes of Fed Chair Powell and the BoE’s Governor Andrew Bailey, who are facing an unwelcome policy version of zugzwang, the path shown by CEE curves and the historically unlikely challenge of pulling off the feat of dampening inflation without causing recession, it might just be Czech mate.