DM Rates: The 3 big shifts this year
Developed market interest rates have undergone three different shifts thus far in 2022. The first leg, which lasted through June, was driven purely by shifting policy expectations as inflation headed sharply higher. However, given the pace of rate increases across the different tenors, the tightening in financial conditions prompted a rapid reassessment of the economy. Typically, stresses of that magnitude point to a meaningful slowdown in economic activity. During that run, 10Y UST and 10Y German bund yields touched their respective highs of 3.50% and 1.80% respectively. Similarly, 10Y JGB yields hit the ceiling of 0.25% as speculation mounted on the BOJ tweaking YCC. The yield reversal in July (we called peak duration fear in early July) and early August was stunning. 10Y UST yields dropped close to 100bps from peak to touch 2.51%. Similarly, 10Y bund yields dropped below 1% as ECB normalization bets got shelved. Market participants were discounting hard-landing as the base case, which we disagreed with. We always thought a soft landing was more likely. Accordingly, our yield forecasts (10Y UST and 10Y bund were are 3% and 1.5% respectively) looked high compared to the market.
This brings us to the current setup where DM yields spiked across the board since mid-August. There was no single signal to this. We would attribute this adjustment as being broadly data driven as labour market statistics in the US and Europe looked robust. Economic indicators look resilient and stronger than what a soft landing would look like. Accordingly, we adjusted our rates forecasts higher across USD and EUR rates, paring the odds of a near term recession. However, the latest CPI and PPI prints this week proved to be pivotal for the rates space. Resilient growth and still hot inflation might well require a more forceful response from central banks. The terminal rate pricing for the Fed went up by close to 50bps post CPI release. Similar adjustments were seen across EUR, GBP, AUD rates. The upshot is the data thus far has been supportive of further tightening, and fading Fed cuts in 2023 (relative to the 2Q23 peak priced) makes sense. There might also be a bit of complacency on inflation expectations in longer term rates. Meanwhile, EUR rates are biased higher, with the curve flatter, as the ECB continues to fight inflation. Lastly, markets will be watching to see if the BOJ will be uncomfortable enough to adjust YCC. Thus far, the authority has only resorted to verbal warnings amidst yen weakness. We would highlight that it is extremely difficult for the market to force the BOJ to move. It would likely boil down to a deliberate choice from the policymaker.
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