Government Bonds: Outlook 2022
By Florian Sp?te , Senior Bond Strategist at Generali Investments
After terminating bond purchases in spring 2022 we expect the Fed to kick off a new rating cycle and hike three times in 2022. While this is almost priced, we differ regarding the long-term outlook. Amid concerns about a slowing of the economy in 2023 and a corresponding strong decrease in inflation financial markets currently expect the peak of the Fed policy rate at 1.5%. As outlined in the macro section, we are more constructive on the growth outlook and expect US inflation to decline only slowly. Hence, we forecast a peak key rate above 2%. While we do not share the Fed’s own longer-term expectation of 2.5% the central bank will hardly ignore consumers’ concerns about high inflation. Accordingly, we expect that financial markets will adjust expectations over the course of 2022.
This will give leeway for long-dated US yields to increase. While forwards only imply a level of 1.65% until the end of the year, we see scope for 10-year US government bond yields to rise to 2.0%. The bulk of the yield adjustment is likely to be borne by the real component. If history is any guide the end of quantitative easing and the start of a new key rate cycle will impact mainly real yields. Nevertheless, they will remain at a comparatively low level and even 10-year real yields will continue to be well in negative territory. It should not go unmentioned that the forecast is subject to a greater degree of uncertainty than usual. In particular, the development of Covid-19 is an important factor. Accordingly, we do not expect a sustained yield increase until concerns about new variants and further waves have been overcome - which we assume in our basic scenario.
As we do not deviate substantially from market pricing regarding the Fed stance for 2022 and 2023, we expect the short end of the curve to move upwards largely in line with priced expectations. Until the end of 2022, we forecast 2-year US yields to reach 1.35%. Hence, the flattening of the US curve is seen to continue over the course of 2022.
The situation in the euro area is less straightforward as the ECB can afford to adopt a less hawkish stance. Inflation pressure is less pronounced, and we forecast annual inflation to move back towards the target over the course of 2022. Notwithstanding that, the central bank will also show its teeth and will increasingly reduce the degree of policy accommodation. However, the currently priced 10 bps hike of the deposit rate until the end of 2022 appears too ambitious. However, the long-term expectations appear too low. Financial market expect that the ECB deposit rate will remain in negative territory even in five years. As in the US, we forecast an adjustment of market expectations over the course of 2022.
Moreover, we forecast the ECB to scale back its bond purchase programme. Depending on the evolution of the macroeconomic situation we forecast the ECB to almost halve the volume it will spend on euro area sovereign bond markets. This is not only because it will reduce the total volume, but also because it will buy more EU bonds. With a volume of around € 200bn, the EU will be the largest net supplier of EUR-denominated government bonds in 2022. The forecast decrease in net supply across euro area countries by more than € 140bn will not be sufficient to make up for the reduced ECB purchases. Hence, net-net supply will be positive again. We expect a volume of just under € 100bn (a swing of almost € 100bn compared to 2021).
The combination of increasing US yields, an expected adjustment of long-term key rate expectations, less ECB support, and an economy still growing above potential will contribute to a rise in long-term yields. While forwards only imply a slight increase of 10-year Bund yields to -0.25%, we forecast a level of 0.10% by the end of 2022.
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Again, the increase will largely be driven by higher real yields amid a by and large fairly priced inflation outlook. Even considering the increase, real yields will remain clearly in negative territory and just exceed the -2.0% threshold. A stronger upward movement appears unlikely as asset valuation and debt sustainability depend on low real yields. Hence, there is a self-correcting mechanism that prevents a too strong yield increase.
As a first ECB key rate hike is not on the cards for the time being, we see only a very moderate upward trend of short-dated yields. Accordingly, the steepness of the yield curve will to a large extent be determined by the development of the long end.
Declining ECB support to leave its mark on euro area non-core bonds
Despite a moderate upward trend since autumn euro area non-core government bond spreads are still rather low by historical standards and they look vulnerable to a shift in the narrative from the ECB. The tighter central bank liquidity will dampen the current carry-friendly low volatility environment. Moreover, the forecast increase in core yields will reduce the search for yield. Additionally, the political environment will become bumpier in 2022. Presidential elections both in Italy and France have the potential to have a lasting impact on the currently calm political environment and cause some market turmoil. Finally, as outlined above the technical situation will deteriorate. The increase in the net-net supply in the euro area is almost entirely due to higher net supply from Italy, Spain (and France).
Notwithstanding that, solid growth, still accommodative monetary policy, and the support from NextGenerationEU will prevent a disorderly increase in risk premiums. Overall, we forecast a moderate spread widening, which will probably eat up the carry.