The pandemic has run for close to two years. Between restrictions, vaccines and treatments, much of the world has managed to live with COVID-19. In the Developed Market space, where vaccine deployment is generally faster than the developed world, the economic bounce in the first half of the year was strong and economies generally managed to overcome the Delta variant without too much of an impact to growth or the markets. The general theme of re-opening continues with international travel as the next big leg of normalisation. While the impact would not be anywhere close to what we saw post-lockdown, the fact is that the world is exiting the Pandemic. Accordingly, major central banks are exiting exceedingly loose monetary policy.



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.

Rates Strategy
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.