Mark Holman (Vontobel AM) | The Fed’s QE programme of $80bn in Treasuries and $40bn of mortgage-backed securities (MBS) purchases per month is already being tapered with $10bn less in Treasuries and $5bn less in MBS as each month passes. In our opinion the Fed should have already finished tapering by now, but they have only just begun and at a very slow pace, suggesting it will take seven further policy meetings to complete.
Given our fear of the Fed being behind the curve, we think the pace of tapering will be increased at the December 15 meeting and will be completed at the March meeting, thereby giving the Fed some much needed flexibility to hike sooner if it needs to deal with a rapidly declining unemployment rate.
We would like to see a gap between tapering and the first rate hike, with our base case being that the first hike comes in September, though ending asset purchases in March does leave the door open for a hike in June if needed. We’d expect a first hike in September to be followed by a second before the end of year, taking the upper bound of the Fed Funds Rate to 0.75%.
A Fed in tightening mode usually means upward pressure on the yield curve, and this coming year should be no exception with lingering inflation concerns meaning a series of hikes will get priced in. Consequently it is very hard to see a 10-year Treasury yield below 2% by year-end 2022 (our central forecast is 2.10%), meaning another year of losses in the world’s benchmark risk-free asset. Clearly this is a risk we would encourage investors to sidestep while yields rise, but higher Treasury yields are going to be a very useful asset in future, so we would view this as good news.
Europe and the ECB
On one hand this might be the easiest call for us as it’s very hard to see the ECB getting away from its minus 50bp deposit rate in 2022. In fact, it takes a bullish view to see them getting back above zero in the whole of the next cycle, but that’s one for next year once we know just how much of the current Eurozone inflation becomes more ingrained.
The more tricky forecast is what the ECB will do with its two ongoing QE programmes, namely the Pandemic Emergency Purchase Programme (PEPP) which is currently buying €70bn of sovereign debt a month, and the old Asset Purchase Programme (APP) which is buying €20bn a month. We could debate whether these two programmes are required at all given the recovery and also the inflation data, but the influence of both of these programmes on the market is significant and their withdrawal would be a negative shock. The conundrum is that the PEPP is due to complete in April, though coupons and redemptions will be reinvested at least through 2022, but a drop of €70bn a month is probably too much for the market to digest, especially in the face of the rising euro sovereign yields we are forecasting. Consequently we think the ECB will temporarily increase the APP and then try to ween the market off this increase in 2023. Our central forecast is for the APP to be boosted to €50bn a month to avoid an unwanted tightening of financial conditions.
What does this mean for 10-year Bund yields, which currently sit at negative 29bp? Despite the more supportive ECB the correlation to Treasuries is too strong and the market will be looking ahead to the phasing out of QE by the end of next year, so Bunds are not immune to rising yield curves. We see them going to 0.00% by year-end 2022, once again providing a loss for the calendar year of around 3%. As with Treasuries above, we think this risk is easily avoided through portfolio construction, or in fact through hedging, where carry costs are currently minimal.
The UK and the BoE
This is perhaps the hardest call of them all given the UK’s additional inflation concerns, labour market pressures and supply chain issues stemming from Brexit, and of course the seemingly never ending political risk that has shrouded the UK since its decision to leave the EU.
Having said that, the Bank of England has erred on the side of excessive forward guidance which eventually must come through. We expect a base rate rise to 0.25% at the BoE’s December 16 meeting, and an additional three 25bp hikes in 2022 taking the base rate to 1.0% by year-end. QE will have stopped by the end of this year, with a stock of Gilts standing at £875bn and a stock of corporates at £20bn. The BoE has been quite clear that once base rates go to 0.50% it will no longer reinvest coupons or redemptions, but it has also said that at 1% it would begin to sell down the portfolio of Gilts, which currently makes up 50% of the outstanding issuance of conventionals. We see this as unhelpful forward guidance and something that may weigh on Gilt yields as the base rate gets closer to this 1% goal.
Our forecast for Gilts is once again for negative returns, with the 10-year moving from 0.99% to 1.40% by the end of 2022. Again, however, this is a risk that can either be minimised through portfolio construction or hedged relatively cheaply through highly liquid interest rate swaps.
