Summary

1. Central banks Fed and ECB. End of the phase of a sharp and rapid rise in policy rates, start of the phase of more moderate rate increases. We expect end of cycle rates in Q1 2023, 5% for the Fed and 2.75% for the ECB deposit rate.

2. Tactical vs strategy. from a strategic point of view, long- term interest rates remain high on a historical basis, but from a tactical point of view, long-term sovereign bonds are close to overbought territory. Volatility remains high and liquidity of sovereign bonds is deteriorating.

3. Strategically, we remain Positive on US government bonds for dollar-based investors, and Neutral on German government bonds. Long term rates are expected to rise in the coming months, before easing after Q1 2023. Our targets for 10-year bond yields are 3.5% in the US and 2.5% in Germany in 12 months.

4. Plan sailing for BTPs so far. Italian risk premiums have eased recently, but this could change. The Italian spread could widen significantly in Q1 2023 and reach 250bps, which would offer a buying opportunity as the ECB would intervene if the spread were to widen beyond this level for reasons other than budget exuberance. We expect a spread of 230bps at the end of 2023. For the moment, we are keeping a Neutral stance on Italian sovereign debt.

5. Strategically, opportunities in corporate and emerging market bonds. We are Positive on US IG corporate bonds for USD-based investors. We are Neutral on EUR IG corporate bonds. We favour quality corporates in the eurozone. Cross-assets valuations favour IG corporate bonds over HY. We are positive on EM bonds, in hard and local currency. Risks seem priced in. We prefer commodity exporters and quality issuers. 

Central banks

Smaller rate hikes but hawkish tone

European Central Bank (ECB)

The ECB revised its inflation projections substantially upwards: It sees core inflation at 4.2% at the end of 2023, 2.8% at the end of 2024 and 2.4% at the end of 2025, well above the target of 2%, despite the 250 bps rate increases made in 2022.

The ECB's new ‘hit and stay’ credo resembles the Fed's ‘higher for longer.’

Monetary tightening is not over: The ECB will continue to raise policy rates and reduce money supply by encouraging banks to repay long term loans at reduced rates (TLTROs) and by starting Quantitative Tightening (QT) in March 2023 (by not reinvesting all of the bonds on the APP portfolio that will mature).

Our expectations: We are more confident than the ECB about the future fall in inflation. We expect two rate hikes in Q1 2023 for 75bps, which will lead the deposit rate to 2.75%, which we consider to be the end of cycle rate.

US Federal Reserve (Fed)

Inflation is falling significantly, but is still too high: the Fed will have raised interest rates by 425bps in 2022, one of the fastest monetary tightening in history! But it is not over, because it is planning a further 75bps by December 2023.

The market does not believe the Fed: the market expects inflation to fall much more rapidly than the Fed, to 2.5% in 8 months. As a result, the market sees the start of a rate cut cycle as early as Q3 2023.

Economic projections for 2023 revised downwards: the Fed expects less growth, more inflation and more unemployment compared with the latest projections in September. This suggests a higher probability of recession.

Our expectations: a last rate hike of 50bps at the next Fed meeting in February 2023 to take the federal funds rate to 5%, then a long pause to avoid the scenario of inflation returning (remember Volker in the 80s). We forecast 100bps rate cuts in 2024.

US Federal Reserve (Fed)

Inflation is falling significantly, but is still too high: the Fed will have raised interest rates by 425bps in 2022, one of the fastest monetary tightening in history! But it is not over, because it is planning a further 75bps by December 2023.

The market does not believe the Fed: the market expects inflation to fall much more rapidly than the Fed, to 2.5% in 8 months. As a result, the market sees the start of a rate cut cycle as early as Q3 2023.

Economic projections for 2023 revised downwards: the Fed expects less growth, more inflation and more unemployment compared with the latest projections in September. This suggests a higher probability of recession.

Our expectations: a last rate hike of 50bps at the next Fed meeting in February 2023 to take the federal funds rate to 5%, then a long pause to avoid the scenario of inflation returning (remember Volker in the 80s). We forecast 100bps rate cuts in 2024.

Investment Conclusion

The first phase of the monetary tightening cycle, that of raising rates quickly and strongly, is over. Fed and ECB policy rates are now seen as restrictive. These two central banks are now entering a second phase, that of more moderate rate increases towards the end of cycle rate. We expect end of cycle rates in Q1 2023, at 5% for the Fed and 2.75% for the ECB deposit rate. Then comes the third phase, that of the pause. Then the fourth, the pivot, where central banks will lower rates, probably in 2024, in response to a potentially marked economic slowdown.

Bond yields

Down over the past month

Rate volatility is very high, twice as much as the long-term average.

Liquidity is deteriorating due to volatility, central bank tightening and the approach of the Christmas holiday. Interest rate volatility should then fall and liquidity should improve next year as inflation becomes under control once again.

Valuation: from a strategic point of view, long-term rates remain high historically, but from a tactical point of view, long-term sovereign bonds are close to overbought territory.

Catalysts: the evolution of inflation and the reaction of central banks have been the main driver of interest rate movements in recent quarters. As inflation becomes under control once again, interest rates should be further impacted by reduced flows and very high issuance volumes in Q1 2023, implying higher long-term interest rates. Thereafter, they should fall as the economic slowdown will be felt.

Investment Conclusion

From a strategic point of view, long-term interest rates remain high on a historical basis, but from a tactical point of view, long-term sovereign bonds are close to overbought territory. Strategically, we remain Positive on US government bonds for dollar-based investors and Neutral on German government bonds. Our targets for 10-year bond yields are 3.5% in the US and 2.5% in Germany in 12 months.

Theme in Focus

Plain sailing for BTPs so far

Honeymoon since the elections: the arrival in power of Ms. Meloni's populist government has not triggered a widening of risk premiums as feared. On the contrary, the Italian spread has narrowed considerably and moved away from the danger area where the market usually starts to worry about debt sustainability.Four main reasons: 1) no confrontation between Ms. Meloni and the European Union so far; 2) appointment of a finance minister deemed to be a moderate and relatively pro-European member; 3) government deficit for the 2023 budget under control, and 4) Italy has received EUR 67 billion from the European post-pandemic recovery fund since 2021.But...Ms. Meloni wants to change the rules of the European Recovery Fund to take into account higher energy and commodity prices. Negotiations with the European Commission are expected to begin in Q1 2023.Delays with major reforms: the government must still vote on some 20 measures before year-end to secure the EUR 20 billion loan from the European Recovery Fund.Difficulty in spending: Italy has spent only one third of the EUR 42 billion received this year, in particular because of red tape, rising energy prices and postponed projects owing to the discovery of archaeological remains in different places.A balanced budget must be found: the projected deficit seems to be under control, but some people criticise the lack of realism of the 2023 budget, claiming that it is based on forecast growth of 0.6% in 2023, which contrasts with the view of most economists (-0.1%) and that of BNP Paribas (-0.4%).Clouds on the horizon: a strong increase in net sovereign issues is expected in Q1 2023, in a context of higher interest rates and, barring any exogenous shocks, no support from the ECB. Thus, the fate of new Italian sovereign issues will essentially depend on the appetite of local and international investors, given that domestic banks have reduced buying capacity.

Investment Conclusion

We have a Neutral stance on Italian sovereign debt. The Italian 10-year spread could widen significantly in Q1 2023 and reach 250bps, which would be a buying opportunity as the ECB would intervene if the spread were to widen beyond this level for reasons other than budget exuberance. We expect a spread of 230bps at the end of 2023.