December 2021 / GLOBAL MARKET OUTLOOK
Navigating Policy Shifts
Risk of central bank missteps could keep bond markets volatile in 2022.
With inflation emerging as both a leading investment risk and a hot political issue, a turn toward higher interest rates appeared to be underway as 2021 ended. Yet, with COVID‑19 still clouding the outlook, global central banks were moving at different speeds.
As usual, the Fed holds center stage. As of late 2021, market expectations were rising that the Fed would begin tapering its quantitative easing bond purchases at a faster pace early in 2022.
But there may be a disconnect between investor perceptions of Fed policy and the inflation expectations priced into fixed income yields.
According to Vaselkiv, many investors came to the conclusion in the second half of 2021 that Fed Chairman Jerome Powell was being “irrationally dovish” in continuing to focus on U.S. unemployment even as inflation accelerated.
But Thomson argues that market indicators as of mid‑November 2021 were reflecting a less bearish view. “Whether it’s long‑dated rates or Treasury Inflation Protected Securities, the markets are saying that inflation is a transitory effect.”
A key question could be whether market expectations are compatible with the Fed’s 2% long‑term inflation target, Page argues. While that target is flexible, five‑year break‑even rates (the spreads between yields on TIPS and on regular Treasuries with equivalent maturities) as of mid‑November 2021 suggested that the market was anticipating 3% U.S. consumer inflation. The Fed’s credibility could be on the line.
“There’s being flexible around 2%, and then there’s letting inflation average 3% over the next five years,” Page observes. “Something will have to give.”
Vaselkiv says he sees two potential interest rate scenarios for 2022:
- The Fed remains too dovish for too long, causing the yield curve (the spread between short‑ and long‑term Treasury yields) to steepen. That could push the benchmark 10‑year U.S. Treasury yield above 2%.
- The Fed is forced to raise rates faster—and possibly higher—than markets expect. In that scenario, the yield curve could flatten and the 10‑year Treasury yield could fall as investors begin to anticipate a negative shock to growth.
Some Central Banks Have Raised Rates, but Credit Conditions Appear Favorable
(Fig. 1) Interest rate actions by global central banks and upgrade/downgrade ratio for U.S. high yield issuers
While continued strong economic growth and inflation potentially could pose significant risks for U.S. Treasuries and other low‑yielding sovereign sectors in 2022, they’ve produced something close to “nirvana” for global credit investors, Vaselkiv says.
Recent indicators of corporate credit quality reflect that blissful state, Vaselkiv notes, with the default rate on floating rate bank loans below 1% as of mid‑November 2021 and the upgrade/downgrade ratio among U.S. high yield issuers approaching 1.8‑to‑1.
In Vaselkiv’s view, floating rate bank loans could offer particularly attractive potential opportunities in a rising interest rate environment because their rates typically reset every 90 days, giving them the shortest duration of any credit sector.
But history suggests that ideal credit conditions don’t last forever, Vaselkiv cautions. The dynamics supporting credit quality—ample liquidity, solid earnings growth, low balance sheet leverage—also could facilitate a shift to riskier financial practices.
“I see a flashing yellow light that over the next year or so credit quality could begin to deteriorate,” Vaselkiv says, as companies use low‑cost debt to pursue merger and acquisition deals and banks offer easier financing for private‑equity transactions.
With credit spreads (the yield differences between bonds that carry default risk and comparable U.S. Treasury securities) historically tight across nearly every U.S. credit sector, investors may need to cast a wider net in 2022.
EM corporate debt is the one global credit sector that still appears extremely cheap, especially in Asian markets, Vaselkiv contends. However, a positive outcome for Asian credit in 2022 will require a successful stabilization of China’s economy, he adds.
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