Starting with a Bang

Long-term interest rates started 2022 with a “bang”, reacting – rationally in our view – to a surprisingly hawkish batch of Fed minutes pointing to an early beginning of the reduction of its balance sheet. It may well be that the US central bank was increasingly frustrated by the curve flattening which had been the main market reaction to the telegraphed series of Fed Funds hikes. The stubbornly low level of 10-year yields threatened to “drown” much of the Fed’s intended monetary tightening.

Now that the market, a few days into the new year, has hit the interest rate levels we had been forecasting for the end of 2021, we want to question our forecast for the end of 2022 (2.0% for a US 10-year yield). We are not convinced we need to upgrade it. True, the latest data confirm the pace of wage growth is very high in the US, adding to the sense inflation is now largely endogenous over there, but with Biden facing more and more difficulties to achieve anything substantial on his latest tax and spend package – and the perspective of a Republican victory in the mid-terms – the US fiscal stance could turn quite sharply this year and next. In addition, while tapering is not necessarily the trigger of a correction of the equity market, a proper reduction in the size of the Fed’s balance sheet could be much more detrimental to risky assets. Given the sensitivity of the US real cycle to wealth effects, this is not something the Fed could completely ignore. So all in all we are inclined to stick to 2.0% by the end of 2022 for US 10-year rates, but with a significant risk that yields follow this year a “bell curve” and exceed these levels at some point in the first half of the year, especially if the expected slowdown in inflation is delayed.

While the hawks at the ECB continue to express their concerns over inflation, we think that for now the “status quo” of December 2021 can be maintained there, with the “big decisions” on policy rates pushed into the end of this year and more likely into 2023. However, the ECB is tapering its QE programmes in 2022, which reduces the support for the most fragile bond markets. As governments start preparing their fiscal bills for 2023 this summer and the European fiscal rules kick-in again next year, questions around debt sustainability may start to be asked. In this context, we take a good look at the proposal from Mario Draghi’s and Emmanuel Macron’s economic advisors for a reform of the Stability and Growth Pact.