Fixed income dynamics in the current monetary and fiscal landscape

The global economy rebounded quickly during the summer from the coronavirus pandemic. Economic data surprised on the upside, especially in the US. However, the risk of reduced government support, permanent layoffs and business bankruptcies need to be monitored until a vaccine arrives. Economic activity is unlikely to return to pre-Covid levels until 2022.
In this phase of recovery, central banks played a key role in the massive supply of credit to governments and companies. The coronavirus crisis has been characterized by counter-cyclical credit conditions, thanks to unprecedented strong coordination between governments and monetary policy makers. To tackle the health crisis, almost all governments implemented large-scale fiscal stimulus and support measures, including corporate loan guarantees. At the same time, major central banks increased their purchases of sovereign debt to levels never seen before, played a backstop role in the corporate debt market and provided cheap liquidity to banks (in the case of the ECB). We observed:

• On the sovereign debt market, a big wave of new issuance. The crisis has pushed government deficits to historically high levels. However, huge supply did not push up yields, as central bank purchases absorbed most of additional government issuance. In recent months, sovereign long-term yields fell sharply and peripheral spreads in the Eurozone tightened.
• On the corporate bond market, a record level of issuance. The corporate debt market was boosted by the support of central banks. Credit spreads have narrowed even though they have not yet fully returned to their pre-crisis levels on average. Indeed, companies took advantage of historically low yields and strong investors’ appetite to boost their balance sheets and increase their cash holdings. This liquidity cushion has largely contributed to limiting the number of defaults. 

Once the coronavirus crisis phase is over, central banks’ actions will aim to support economic recovery. The governments that initially put in place support measures to help companies to maintain their operating capacity and to prevent households from losing too much income, will, in a second phase, implement stimulus measures. Most of the 2021 deficit estimates for developed economies are likely to be revised upward over the coming months. We expect major central banks to continue to absorb a lot of governments’ extra issuance and to play a backstop role on corporate credit markets.

• The Fed undertook a historic shift in its mandate: its priority is now maximum employment. Fed Chair Jerome Powell said in his Jackson Hole speech that the central bank is adopting a “flexible form of average inflation targeting”, i.e., targeting inflation that “averages 2 percent over time”. The Fed also adopted a new forward-guidance: The benchmark interest rate would remain near zero “until labor market conditions have reached levels consistent with the committee’s assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.” This means that the Fed will wait until a tight job market has begun pushing inflation higher before thinking about rising rates. Otherwise, the Fed also intends to continue its bond purchase program at its current pace ($80bn in Treasuries and $40bnin Mortgage Backed Securities). The message is clear: rates will remain low for at least the next three year to support economic activity. What to expect next? A transition to a traditional asset purchase program buying more longer-maturity securities.
• The ECB adopted a “wait and see” mode at its last meeting despite recent disappointing inflation data and the appreciation of the euro. The ECB increased in June the envelope for the pandemic emergency purchase program (PEPP) by €600bn to a  total of €1,350bn and extended the program to at least the end of June 2021. At the end of August, the ECB had already bought more than €500bn under the PEPP. Otherwise, the ECB’s new economic projections suggest that the monetary stance of its policy will have to remain extremely accommodative. Core inflation is expected to increase only by 1.1% in 2022. We expect the ECB to extend its asset purchase programs (via the APP or the PEPP) to maintain financial stability and ensure a smooth transmission of monetary policy.

What are the implications on the fixed income market?

Since the Fed successfully addressed liquidity tensions in the Treasury markets through unlimited Treasury purchases, the main trends on the bond markets have been:
1. A strong decline in US real yields, driven by: (a) a dovish Fed supporting the recovery (b) the move to an Average Inflation Targeting framework, which means that the Fed will hike later in the cycle than it would have under its previous monetary policy framework. The decline in yields was stronger in the 5Y segment, as expectations of a rate hike were pushed forward to 2024. Since the beginning of May, 5y, 10y and 30y real yields have declined by 95bp, 53bp, and 17bp, respectively.
2. Limited nominal yield changes because the fall in real yields was offset by a rise in inflation break-evens.
3. A steepening of the yield curve as the difference between the yields on five-year and thirty-year Treasuries widened by 25bp.