The war in Ukraine will definitely hurt the global growth but boost inflation.
The war in Ukraine will act as a negative supply shock to the global economy. It will hurt economic growth but boost inflation through higher commodity prices, tighter financial conditions and more disruptions to global supply chains. Europe will be most affected, due to its geographical proximity and its dependence on Russian oil and gas.
The Development of the Inflation Rate
The bigger problem for the U.S. lies on the inflation front. In February, inflation hit 7.9 percent, its highest level in 40 years. And that was before the start of the war. During the first two weeks of the Russian invasion, commodity prices rose by another 25 percent, according to the S&P index, though initial steps towards peace talks have relieved some of the upward pressure on prices.
Still, the facts on the ground suggest that the situation is escalating and that any near-term resolution to the conflict remains elusive. U.S. inflation is likely to rise to about 8.6 percent over the next few months (see below).
Exhibit 1
(Source: Macrobond. Data as of 22.03.2022, click graphic to enlarge)
The Fed Will Tighten Policy Until There are Clear Signs That Inflation is Coming Back Towards its 2 Percent Target
Given these circumstances, the Fed has no other choice but to bring the monetary stance back to neutral and then into tight territory as quickly as possible. The latest Summary of Economic Projections, which was published alongside the FOMC meeting on March 16, shows that the «median» official expects the policy rate to reach 2.75 percent by the end of 2023, exceeding their collective estimate of the neutral rate – the rate at which monetary policy is neither simulative nor restrictive – by 35bp.
In addition, the balance sheet runoff, which could start as soon as May, will also contribute to tighter financial conditions. In short, the Fed is clearly committed to bringing down inflation, and it will continue to tighten policy until there are clear signs that inflation is coming back towards its 2 percent target.
While we think it will eventually succeed, its fight against inflation is likely to cause some collateral damage to both growth and the labor market.
The Dollar Rates Market has Experienced a Very Meaningful Repricing
As a result, the US rates market has experienced a sharp and accelerating repricing of rate expectations. Implied policy rates over the next twelve months have surged from 0.25 percent just six months ago to 2.6 percent today (see below), which, incidentally, is close to (restrictive) levels the Fed has indicated in its dot plot for end-2023.
Exhibit 2
(Source: Bloomberg. Data as of 22.03.2022, click graphic to enlarge)
What is more, Quantitative Tightening (QT) is likely to reduce the size of the Fed’s balance sheet substantially, which could be equivalent to an additional one or two rate hikes per year according to various estimates.
Consequently, we are looking at a very rapid and very substantial tightening package, with the objective of weakening demand enough in order to reduce inflationary pressures. But unlike previous hiking cycles, this will be done at a time when the economy is already decelerating.
The Yield Curve is Already Flashing Orange
Unsurprisingly, the yield curve has started to flash warning signs. After flattening sharply for the past 12 months, it has started to invert at distinct pivots in maturities, indicating the risk of a more meaningful economic slowdown, due to aggressive tightening.
The implied three-month rates taken from the euro-dollar forward market exemplify this phenomenon nicely: a sharp rise in short-term rates followed by lower money market rates (see below).
Exhibit 3
(Source: Bloomberg. Data as of 22.03.2022, click graphic to enlarge)
We Expect Further Underperformance of Short and Intermediate Maturities Relative to Long Dated Treasuries
The current flat to slightly inverted yield curve does not necessarily indicate a firm top in yields just yet. With inflation moving higher in the coming months, it may well be that markets price a more aggressive policy rate trajectory, pulling long-term yields up in the process, though distinctly less than short rates.
Additionally, QT could slow down the flattening or the inversion of the yield curve for a while, but will not be able to prevent it. Consequently, we continue to expect further underperformance of short and intermediate maturities relative to long-dated Treasuries.
There Should be Some Good Entry Points Over the Coming Months
Still, we think that the necessary conditions for long-term yields and inflation expectations to start forming a top are falling into place: First, a distinct path towards accelerated tightening accompanied by markedly higher yields and second a U.S. economy that will need to slow more markedly to bring down inflation.
We note that the dollar rates market has experienced by far the sharpest repricing compared to other asset classes. Moreover, the current environment will probably be more challenging for risk assets. So in our view, the risk/reward for U.S. government bonds is improving fast and we are looking at attractive entry points over the next few months.
We Recommend a More Balanced Asset Allocation Between Risky and Safe Havens
So how should fixed-income investors approach this complex environment? During the post-COVID crisis, fixed income strategies were heavily geared towards higher-yielding bonds, which benefitted from central bank support and a strong appetite for risk assets.
We are now entering a phase in which investors need to adapt to tighter financial conditions and higher rates. Within the fixed income segment, we have a preference for a more neutral tilt across different segments, emphasizing the need for a sound balance between high-quality and sub-investment grade assets.
Consequently, investors should increasingly favor more defensive segments within their fixed income portfolios, with a greater share in highly liquid bonds, i.e., government ones. While there is upward pressure on sovereign rates for now, sharply higher yield levels are starting to present opportunities for fixed-income investors with a medium-term horizon and a preference for high quality.
