End of easy money looms

As the curtain falls on the era of pandemic-induced easy monetary policy, bond markets are readjusting. In a week heavy with central bank action, the FOMC took centre stage and all but confirmed November 2021 as to when tapering of asset purchases will begin and also pointed to the possibility of rates going up in 2022, earlier than previously indicated. But the Fed wasn’t the only actor, with the Bank of England also giving indications that it was preparing to tighten policy due to mounting inflation pressures affecting the UK economy. In the background, at least for developed markets, Norges Bank raised rates by 25bps and lined up another hike for December.

After an initial muted response to the Fed’s messaging of tighter policy ahead, US Treasuries sold off heavily toward the end of the week, with yields jumping considerably on Sept 23rd. All told the curve bear steepened over the week with 2yr UST yields up 5bps to 0.2695%, their highest level since March 2020, while 10yr yields jumped to 1.4509% over the week, adding 9bps. Gilts showed a similarly aggressive move with 2yr gilt yields up 9bps to 0.377% and the 10yr yield adding 8bps to 0.9240%.

Barring any substantial deterioration in economic conditions in either the UK or US economy, the likelihood of yields remaining high or pushing even further upward looks strong. Our own forecasts project the 10yr UST yield at 1.65% by end of Q4 while 10yr gilt yields have already pushed beyond our expectation of 0.9% by end of the year. Tighter policy, elevated (if transitory) inflation and expectations for consistent economic growth will help support yields rising into 2022 as well.

Still some risks to tightening policy

But downside risks to yields remain apparent. Market attention will switch away from the Eccles Building home of the Fed and down the Mall to the Capitol where Democrat party infighting threatens their own legislative agenda while Republicans show no apparent urgency to support plans to raise the debt ceiling. Longer-dated USTs could actually receive a flight to safety bid if there is anxiety that the US Treasury fails to meet any payment obligations; which we doubt is likely as cuts would probably fall on government wages or social payments before interest payments.

In the UK, the BoE will have to monitor the labour market implications of the end of the government’s furlough scheme, which expires at the end of this month. An upward surge in unemployment at a time when inflation is being driven higher by exogenous energy market risks could stay the BoE’s hand on wanting to move tighter on policy.

Policy gap with low yielders will widen

The divergence in policy between the Fed/BoE and ECB/BoJ is growing increasingly clear. We doubt that tighter policy will emerge in either the Eurozone or Japanese economy in any meaningful way in 2022 with rates held low and asset purchases continuing in some form or another. The BoJ also met last week with no change on policy and yields barely showing any movement while short-term bund yields remain anchored around -0.7%. Yield differentials are likely to widen considerably in favour of US and UK assets, helping to support the dollar and sterling and weighing against the euro and yen.

Beyond developed markets, the advent of tighter US monetary policy will weigh acutely on emerging markets too. An index of USD-denominated emerging market bonds fell 0.9% last week, its sharpest weekly decline since March 2021, while aggregate yields for the index added 15bps to 4.09%, their highest level since November 2020. Local currency emerging bonds showed a similar, downward move.

In India, yields on 10yr local currency government bonds rose moderately while South African yields added almost 15bps to 9.471% as the SARB kept rates on hold at yet another central bank meeting last week. Turkish bond yields jumped with the 2030 TRY yields up 123bps to 17.7% as the central bank there cut, rather than raised, rates amid enormous inflation pressures. Pressure will grow on emerging market central banks to maintain inflows and potentially tighter policy further at a time when many of their economies are still early in the stages of pandemic recovery or vaccination programmes. The risk for emerging market assets, whether in FX or bond markets, looks broadly negative until the end of 2021.

Topside for rates may be capped

While we would expect some volatility and adjustment in markets over the end of 2021 and into the first half of 2022, we think that there will be a much lower topside target for rates from the Fed or BoE. The Fed’s own long-term projections are for the Federal Funds Target Rate at 2.5% on the upper bound, the same peak level it reached during the 2015-19 phase of tightening but 275bps below the peak level reached before the 2007-09 financial crisis. We would expect clarity on an end-level for policy rates to become more apparent in future Fed communication which should help to somewhat buffer emerging economies from the final act of easy money.