- War and interest-rate hikes ignite worries about global growth and send ripples through debt markets.
- U.S. Treasury yields will likely trend higher as the Fed signals it will do whatever it takes to curb inflation.
- Despite headwinds, we have a cautiously optimistic outlook for some fixed income asset classes.
The first quarter was a challenging time for global financial markets. Bonds, currencies, and stocks whipsawed due to myriad factors, including rising inflation, Russia's invasion of Ukraine, and the Federal Reserve's first interest-rate increase since 2018. The Russia-Ukraine War has also pushed commodity prices higher and disrupted the global economic recovery. The Bloomberg U.S. Aggregate Bond Index — a benchmark for government and corporate debt — returned –5.93%. Global bonds, as measured by the FTSE World Government Bond Index, returned –6.46%.
Fed Chair Jerome Powell faces the tough task of creating a soft landing for the economy while keeping inflation in check. In mid-March, the Fed lifted the federal funds rate to a target range of 0.25% to 0.50%. Policymakers also penciled in six more increases by year-end, reduced their U.S. growth estimates for the year, and raised inflation expectations. The Fed's latest dot plot, or median projections, show the policy rate rising to around 2.75% by the end of 2023, the highest since 2008. Meanwhile, the European Central Bank held rates steady but said its remaining asset purchase program will wind down at the end of the third quarter.
The bond markets appear to be conveying a pessimistic view of the economy, inflation, and the Fed. At times, yields on some shorter-term Treasuries edged above those of longer-term Treasuries, creating a flat or inverted yield curve. The slope has flashed warning signs of the probability of a recession. By quarter-end, the yield on the 2-year Treasury note had climbed from 0.73% on December 31, 2021, to 2.34% on March 31, 2022. The yield on the benchmark 10-year Treasury note rose from 1.52% to 2.34% for the same period.
Fed signals aggressive rate hikes
The Fed seems to be having a "whatever it takes" moment to slow inflation. But tighten too quickly, and the Fed could further roil markets and tip the economy into recession. Chair Powell has downplayed the risk of a recession and said the goal of tighter monetary policy is to return the economy to "price stability." Rising prices and interest rates signal more volatility ahead for bond markets, in our view. We believe the Treasury yield curve is a reliable indicator of where we are in the cycle and where we are heading. The slope of the 2-year and 10-year Treasury notes indicates the probability of a recession in 2023 is high and rising. But this will be a slow process, in our view.
The Fed expects growth to slow to 2.8% this year from December's estimate of 4%. Fed officials project core inflation at 4.1% in 2022 before declining to 2.6% next year. Consumer prices rose 8.5% from a year ago in March, the fastest pace in more than 40 years, according to the Labor Department. Against this backdrop, job growth remained robust in March. The jobless rate fell to 3.6%, near its pre-pandemic low, and the labor force participation rate ticked up. The Fed sees the unemployment rate for the year falling to 3.5% this year.
ECB faces inflation and growth risks
The European Central Bank (ECB) decided to leave interest rates at record lows of 0%, despite rising inflation in the eurozone. The ECB, however, surprised markets in March by mapping out a speedier exit from asset purchases. Policymakers remain divided over how to respond to the economic shock waves from the Russia- Ukraine War. In the medium term, the energy decoupling between Russia and Europe will continue, pressuring energy prices higher and growth trajectory lower for years. The probability of the euro area falling into a recession in the next 12 months is high.
In the United Kingdom, the Bank of England (BoE) raised interest rates to 0.75% from 0.5% in mid-March. Since near-term inflation is high and there are no signs of a deceleration, the BoE will likely hike again in May, before slowing the pace of future rate hikes. Market volatility has pushed bond yields and borrowing costs higher across Europe. Germany's 10-year bond yield, seen as the benchmark for Europe, surged to about 0.82%, its highest level since 2015. The yield on the U.K.'s 10-year notes moved to a six-year high of around 1.90% in April.
China central bank provides 1 trillion-yuan boost
China has introduced lockdowns in Shanghai and other cities amid surging Covid-19 infections. We believe there will be significant economic costs from these disruptions. In early March, Premier Li Keqiang proposed an ambitious growth target of 5.5% for 2022. Special bond issuances from local governments and cash surplus from state-owned entities will provide fiscal funding. The People's Bank of China (PBoC) said it will transfer more than 1 trillion yuan (around US$158 billion) in profits to the government.
The Treasury curve flattened in Q1 as Fed rate hike expectations for 2022 increased
Source: U.S. Treasury Department. Past performance is not indicative of future results.
China also plans to expand credit and lower effective lending rates, pointing to further cuts in the reserve requirement ratio for banks and the policy rate. In our view, the growth target indicates more policy easing in the near term. The central bank in March unexpectedly held its key interest rate for one-year policy loans unchanged. The PBoC probably maintained the rate to support the yuan amid higher capital outflows. China's benchmark sovereign bond yield has seesawed in recent weeks, with the 10-year notes yielding around 2.78% in April.