Government Bonds: Inflation or Slowdown Risk?
DM government bond markets have seen yields decline into July, as real sector data shows the U.S. economy slowing and debate growing about a recession in the U.S. after a noticeable surge in yields during H1. What happens to government bond yields from here?
Bottom line: Government bond yields' rapid upward adjustment is becoming more two-way, as genuine recession risks exist in a number of countries (U.S./UK/Germany). This will likely restrain central bank tightening as the slowdown helps to bring monthly inflation numbers lower, as waning real incomes rein in company pricing power. We see a choppy phase for DM government bond yields, through into next year, and we see the U.S. discounting 2023 rate cuts.
Figure 1: G4 10yr Government Bond Yields (%)
Source: Datastream, Continuum Economics
Government Bonds Become Two-way
The one-way upward surge in DM government bond yields has finished for now, and government bond yields are torn between high inflation and slowdown/recession risks (Figure 1). The recession risks are seen to be among the greatest in the U.S. for now, and this has prompted a shift from the market discounting a 4% Fed Funds peak to 3.25% — pretty consistent with the view we outlined in the June Outlook (here). The key for the next two months over the summer will be the July 27 FOMC decision and incoming U.S. data including the key employment report on July 8, June CPI on July 13 and retail sales on July 15, but the market will also pick through the second- and third-order data in the U.S. to understand the degree of slowing for the U.S. economy.
While traders and fund managers are shifting toward a technical or mild recession view, the consensus for economists has not yet fully adjusted and is still consistent with a soft landing. The most pessimistic end of the spectrum is for a multiquarter modest recession, rather than a 2007-09 type of U.S. recession. Debt servicing for households and corporates is still reasonable even with the new interest rate structure, while the banking sector is fundamentally stronger than in 2007. However, in the scenario where a harder landing is seen in housing, it could also feed into adverse wealth effects for households (here). Our view outlined in the June Outlook is for a mild recession.
Focus is also growing on whether a technical recession could occur in H1 2022, as the Atlanta Fed nowcast points to a negative Q2 after the decline in Q1. We still expect a positive Q2, though after recent weaker-than-expected data on consumer spending, risks are leaning to the downside of the 2.0% annualized forecast we made with our June Outlook. A negative is possible, but if so it would most likely be on weaker inventories. Domestic demand, which rose by 2.0% in Q1, is likely to remain modestly positive. Q1 GDP was negative only because of a sharp deterioration in net exports. Historic revisions for what looked like a misleadingly weak Q1, and also for a misleadingly strong Q4 2021, are due with Q2's release.
In reality, U.S. government bond yields will now likely be choppy, as Fed expectations currently discounted are reasonable even with a mild recession. Fed Chair Jerome Powell's emphasis on meeting the inflation target means that progress needs to be made on headline and core inflation, as headline inflation impacts long-term inflation expectations and wage and price setting behavior. While progress is being seen on core PCE inflation in the past four months, headline inflation numbers are more mixed and uncertainty is still high on the inflation trajectory. We maintain our view for 10yr yields at 2.90% for end-2022 (here).
Other Key Government Bond Markets
Given the correlation with the U.S., there have also been spillovers into other global government bond markets in H1 2022. However, more important has been the policy function of other DM central banks that have raised official rates or signaled that they will. Inflation pressures from global commodity prices, supply chain disruptions and reopening are global rather than U.S. phenomena. Even so, the underlying inflation trajectory is different across DM. One key contrast is between the EZ and the U.S., with U.S. wage inflation a problem (here) but our view remaining that wage inflation prospects in EZ are consistent with the ECB inflation target (here). Even before formal conventional hiking begins, but incorporating the end of QE, the ECB, somewhat unintentionally, also has presided over a tightening of financial conditions due to wider government bond spreads (Figure 2), which feeds into domestic lending rates in Southern Europe and possible risks to their respective banking sectors. Finally, the EZ faces a radically different wholesale price for gas for consumption and winter home heating, with major divergence over the past month — European TTF is up 103% and U.S. Henry Hub is down 34%. We maintain the view of 25bp ECB official rate hikes in July, September and December, which is still smaller than economists' forecasts. However, we still see 10yr Bund yields at 1.55% end-2022, both as the era of negative official rates ends and as the ECB will likely push up the o/n rate from the deposit rate floor toward the refi rate (here).
Other DM central banks are also going at different speeds. For example the SNB 50bps should be seen as a one-off adjustment and the pace will now be more consistent with the ECB. Norges Bank (here) and Riksbank (here) are making adjustments that cumulatively will be somewhat quicker than the ECB, but we see official rates at 2.50% and 1.75% by end-2023. The BOE will likely follow through with a further cumulative 50bps of tightening in Q3 (here), but we then see a pause. The UK fiscal policy tightening differs from a more neutral stance in most DM countries, while the hangover of Brexit and super high gas prices mean a stagnant economy that the BOE will likely want to avoid plunging into a deeper recession.
Figure 2: 10yr Spread vs. Bunds (%)
Source: Datastream, Continuum Economics
We forecast that the Bank of Canada will increase by 75bps on July 13 and reach a peak of 3% by end-2022 (here). While this follows the broad trajectory of the Fed, the impact on the housing market needs to be watched more closely than the U.S. given elevated house price to income and rent ratios. The same could also be said of the Reserve Bank of New Zealand, where we look for the policy rate to 3.75% by end-2022, which could risk a hard landing for the New Zealand economy. In contrast, we see the Reserve Bank of Australia not fulfilling super-aggressive 2022 market expectations that are still discounted. The July 5 hike of 50bps (here) is a precursor to follow-through aggressive action to 2.50% official rates by end-2022, rather than the 3.00% discounted. Finally, we see the Bank of Japan sticking to its current QE with yield curve control policy until and after Governor Haruhiko Kuroda retires in April 2023. Current high headline inflation of 2.5% contrasts with 0.8% for CPI inflation excluding food and energy, and the commitment to QE with YCC will likely be strong at the July 22 BoJ meeting (here).
Overall, DM government bond markets' rapid adjustment phase in H1 2022 should turn into a choppier environment in Q3. Looking at 10-2yr government bond yield curves (Figure 3), traditional bear yield curve flatterers have been evident, which is consistent with central bank tightening being followed by some long-term confidence in bond markets that inflation will be brought under control. Additionally, 10yr breakeven inflation expectations from index-linked bonds show a similar picture, with the exception of the UK where worries remain that Brexit and other factors could produce a more persistent stagflationary environment than other DM economies. We largely agree with this interpretation, but feel that into 2023 the U.S. slowdown in monthly inflation pressures plus a mild recession in the U.S. will be enough to prompt the Fed to ease by 75bps — which is not discounted in the front end of the U.S. curve or other financial markets.
Figure 3: U.S., Germany and UK 10-2yr Government Bond Curves (%)
Source: Datastream, Continuum Economics
One final note is that EM government bond spreads against U.S. Treasuries are being driven by domestic factors including growth/inflation tradeoffs and the degree of second-round inflation effects being projected. Fed tightening is not causing a tantrum like 2013, both as external balances are better and as FX reserves can provide a buffer against speculative flows. This is not to say that EM will be immune to U.S. developments: Some adverse spillover could still be seen in H2 from global liquidity being impacted by Fed quantitative tightening and stagflation fears. We would see this as being temporary, however, and EM local-currency debt markets such as Brazil will produce double-digit returns through end-2023 (for more see our Markets overview).
Figure 4: EM Government Bond Spreads Driven By Domestic Factors
Source: Datastream, Continuum Economics