DM Rates: Exit Strategy
- The world is exiting the pandemic
- Central banks will also exit very loose monetary policy in 2022
- There will be some divergences in policy tightening pace
- Stagflation worries should ease in mid-2022
The response from DM central banks to the onset of the pandemic crisis in early 2020 was unanimous – slash rates aggressively and buy copious amounts of assets to limit market stresses. To be sure, the European Central Bank (ECB) and Bank of Japan (BOJ) do not have the luxury to do so and they instead ramped up QE. In this crisis, QE became mainstream. In the G3 space, the combined central bank balance sheets grew by around USD 10tn. However, with growth generally holding up (judging from PMI figures across the world) and rebounding post the Delta variant hit, and inflation worries persisting, monetary policy withdrawal is taking place. However, note that the pace of withdrawal will in no way be as aggressive the pace of easing seen in 1H20.
There is significant variation in across the DM with the Reserve Bank of New Zealand (RBNZ), Norges Bank (both of which have hiked rates) and Bank of Canada (stopped QE) standing out as more hawkish. Within the G3, dynamics also differ. The US is arguably facing considerable inflationary pressures. Breakevens are high across all tenors and actual inflation has been high for several months. With wages rising at a pace of 4-5% YoY (note that there no longer is any distortion from the pandemic) and supply-side worries exacerbating matters, it is not surprising that the Fed has already announced taper in November. The Fed also preserved flexibility by only committing to taper at a pace of USD 15bn per month through December, leaving itself leeway to adjust as needed. There is a reasonable chance that the two hikes will get delivered in 2022 if economic momentum is maintained. Meanwhile, the Eurozone will be slower than the Fed. The Pandemic Emergency Programme (PEPP) is likely to be wound down while the Asset Purchase Programme (APP) will probably be expanded to allow QE to continue at a pace of around EUR 30bn/mth. Rate hikes from the ECB in 2022 looks unlikely for quite a few quarters still. Lastly, Japan’s macro data is still very weak. And unlike peers, inflation expectations have stayed anchored. These suggest that there will be no tweaks to the BOJ’s 10Y yield target for an extended period.
…differences in curves
Differences in policy stances would likely mean variations in the respective govvie curves. In the US, there were two waves of adjustment – the first was led by the long end in late 1Q21, followed by a pricing in of hikes in late 3Q21/4Q21. We think that the curve would generally flatten over the coming quarters, broadly tracking the moves seen in previous hike cycles. In level terms, we do think 10Y and 30Y yields are too low, but that may be due to technical factors, When fundamentals reassert, we think 10Y yields can drift into the upper half of the 1.5-2.0% range. Most of this is contingent on the Fed willing to hike and communicate a more hawkish stance. This would drive 2Y-5Y yields significantly higher, with a smaller spillover unto the 10Y sector. We think the German and JGB curve would likely steepen. While the market is factoring a chance of an ECB deposit rate hike in 2022, we think that such speculation is premature. A paring down of asset purchases (which could last well into 2022 or even 2023) suggests that longer-end Bund yields could rise, but the front stay anchored. Peripheral spreads could also come under pressure. For JGB, modest curve steepening is probably on the cards. We would expect JGB to continue outperforming as it did through the two bouts of selloff in 2021. If the 10Y yield target does not shift from zero, the maximum 10Y yields could get to would be 0.20%.
Recovery amidst elevated prices
Our view on rates underscores our expectations of continued global recovery. While emerging markets generally struggled through 2021, the worst is probably over. Moreover, the supply chain logjam that hampered growth in 2H21 should boost growth in 2022. Moreover, international travel may finally make a more meaningful recovery. On the downside, China’s slowdown could prove a drag on global growth. If this gets protracted, global yields could be held down, much like in 2015 and 2016. Lastly, the interaction between inflation and policy making could reach a reckoning. The Fed and the ECB have generally stuck to the transitory inflation stance. If this plays out, we should see a collapse in inflation breakevens, especially in the longer tenors even if the Fed does not tighten and rates stay low. We are taking a nuanced view. Inflation expectations are clearly elevated now but it could be exacerbated by supply chain issues (which should fade in the coming quarters) that comes on top of structural deglobalization and decarbonisation price pressures. The upshot is that we will likely see an improvement in growth / inflation mix in 2022 when as supply chain pressures ease around mid-2022. This should provide comfort for major central banks to undo the monetary easing that got unleashed in 2020.
1) The UST curve will continue to flatten through the Fed tightening cycle. Expressing this view in the 2Y/10Y segment (when spreads are in the 110-120bps area) may be interesting. If the Fed gets really worried about inflation, this spread may narrow towards 80bps by mid-2022.
2) Inflation expectations may be too high in the coming few years. While we do see structurally higher inflation compared to the last decade, we do think supply side constraints will ease in the coming quarters. Accordingly, 5Y breakeven may head back towards the 2.6-2.8% region (from above 3% currently) by mid-2022.
3) JGB outperformance likely to continue in 2022. Japan’s economy is still lagging the global recovery. There are no signs that the BOJ would contemplate shifting yield curve target of around zero in 2022, let alone 2023. As market forces exert on USD rates. We think the 10Y yield spread between the two can widen towards 200bps by end-2022.
To read the full report, click here to Download the PDF.
Subscribe here to receive our economics & macro strategy materials.
To unsubscribe, please click here.
The information herein is published by DBS Bank Ltd and/or DBS Bank (Hong Kong) Limited (each and/or collectively, the “Company”). This report is intended for “Accredited Investors” and “Institutional Investors” (defined under the Financial Advisers Act and Securities and Futures Act of Singapore, and their subsidiary legislation), as well as “Professional Investors” (defined under the Securities and Futures Ordinance of Hong Kong) only. It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. This research is prepared for general circulation. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies. The information herein is not directed to, or intended for distribution to or use by, any person or entity that is a citizen or resident of or located in any locality, state, country, or other jurisdiction (including but not limited to citizens or residents of the United States of America) where such distribution, publication, availability or use would be contrary to law or regulation. The information is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction (including but not limited to the United States of America) where such an offer or solicitation would be contrary to law or regulation.
This report is distributed in Singapore by DBS Bank Ltd (Company Regn. No. 196800306E) which is Exempt Financial Advisers as defined in the Financial Advisers Act and regulated by the Monetary Authority of Singapore. DBS Bank Ltd may distribute reports produced by its respective foreign entities, affiliates or other foreign research houses pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Singapore recipients should contact DBS Bank Ltd at 65-6878-8888 for matters arising from, or in connection with the report.
DBS Bank Ltd., 12 Marina Boulevard, Marina Bay Financial Centre Tower 3, Singapore 018982. Tel: 65-6878-8888. Company Registration No. 196800306E.
DBS Bank Ltd., Hong Kong Branch, a company incorporated in Singapore with limited liability. 18th Floor, The Center, 99 Queen’s Road Central, Central, Hong Kong SAR.
DBS Bank (Hong Kong) Limited, a company incorporated in Hong Kong with limited liability. 13th Floor One Island East, 18 Westlands Road, Quarry Bay, Hong Kong SAR
Virtual currencies are highly speculative digital "virtual commodities", and are not currencies. It is not a financial product approved by the Taiwan Financial Supervisory Commission, and the safeguards of the existing investor protection regime does not apply. The prices of virtual currencies may fluctuate greatly, and the investment risk is high. Before engaging in such transactions, the investor should carefully assess the risks, and seek its own independent advice.