Macro & FICC Research Published: 2021 11 05 06 53
SEB FI & FX Strategy
Stop-loss parade on a bumpy road to lift-off
Summary:
In market focus. Energy prices; Supply bottlenecks; Inflation; Earnings season; Bumpy road to lift-off.
Global macro and risk appetite. We foresee only a moderate rise in the US and euro area long rates in the coming months, which should lend support to the risk sentiment. However, the discrepancy in the macro outlook priced by equity and bond markets bears watching and constitutes a potential source of volatility beyond rates markets, where implied vols have turned higher.
Fed: Tapering as expected – conditions for rate hikes may be met in H2 2022. The Fed will reduce asset purchases by USD 15bn per month, expecting to finish tapering in June while being prepared to adjust the pace as warranted. The Fed aims to keep rates unchanged until maximum employment has been reached, which could be in H2 next year. The Fed’s somewhat more hawkish formulation on inflation and preparedness to act support market expectations of two rate hikes in 2022.
US inflation: Accelerating again, adding pressure on the Fed and markets. After recent more moderate readings, we foresee US inflation accelerating again with core-CPI rising from 4.0% y/y in September to over 5% early next year before base effects start pushing inflation rate lower in April. The Fed’s preferred measure, core PCE, is predicted to rise to 4.5% and stay above 3% most of next year. Our upwardly revised inflation forecast suggests that US short rate expectations will remain under upward pressure.
USD rates: Gradual rise in long rates remains our base case. Since Q2, markets have moved to pricing much more aggressive rate hikes for 2022 2023 while slashing longer term expectations. A notable increase in the 10y yield would require long term rate hike expectations moving decisively higher. We expect markets to price aggressive rate hikes for the coming 2 3 years but a much more modest increase in the tail of the short rate trajectory. Accordingly, we continue to predict only a moderate upside in the 10y Treasury yield in the coming months, targeting 1.80% in mid 2022.
ECB: No new post-PEPP policy signals. At its meeting last week, the ECB saved decisions on the post-PEPP era policy to the December meeting in line with expectations. We foresee the ECB to smoothing the transition to the post-PEPP era either by adjusting the APP or introducing a temporary post-pandemic programme to safeguard favourable financing conditions. Read our review of the October meeting here.
EUR money market: Too aggressive for 2022, but a repricing likely to take time. President Lagarde’s lacklustre effort to tame rate hike expectations left markets empty handed with expectations for 2022 unlikely to fade away any time soon. Euribor fixings have come under downside pressure in the past week.
We don’t foresee the Eurosystem excess liquidity declining nearly as much as forwards for 2022 are suggesting (more here). We maintain our Euribor Dec22 (ERZ2) longs.
EUR rates: Curve steepeners becoming attractive. We think that markets will over time push ECB rate hike expectations further out on the curve, resulting in the short end of the EUR IRS curve trading below forwards in 2022 with the curve trading at steeper levels than priced by forwards.
EUR/USD: Fed support for stronger dollar. EUR/USD has fallen by 0.8% since our previous biweekly strategy and is increasingly heading for the downside after the peak on 28 October. The Fed’s tapering decision has provided further support for the move lower and, as our main scenario now is a rate hike already in H2 2022 and a slightly faster pace thereafter, we lower our EUR/USD forecasts to 1.15 in Q4 and 1.14 in Q2 2022.
EUR/USD: Deeper dive into the rates factor in the STFV model. We take a closer look at the outlook for the spread between the 2y EUR and USD swap rates, which constitutes the rates factor in our EUR/USD model.
Decomposing the rates spread to underlying rate hike expectations (OIS) and the IRS vs. OIS spread, we conclude that the rates factor should remain generally supportive for lower EUR/USD in months to come.
Norges Bank: Cementing December hike. In line with expectations, Norges Bank stayed put at 0.25% on Thursday, reiterating that “the policy rate will most likely be raised further in December”. Economic developments have been broadly as projected in the September MPR and the inflation outlook appears balanced. Hence, the rate path from September is still valid implying three additional hikes in 2022. The decision was widely as expected and did not result in any major market moves. Read our review here.
Scandies: SEK strength to abate while NOK weakness should continue. EUR/SEK has in October mainly been driven lower by corporate event flows that have been SEK positive. Thus, we expect a return back into the 10.00 10.30 range that otherwise has prevailed in 2021 (more in What’s up Sweden). Meanwhile, EUR/NOK has, in accordance with our expectations, risen lately and we see further potential on the upside for EUR/NOK and downside for NOK/SEK where there also is a robust seasonal pattern in October-December for lower NOK/SEK (more in What’s up Norway).
Money market monitor. As a new feature, we introduce charts showing forward pricing for short rates in the US, euro area, UK, Sweden and Norway. See charts at the end of the report.
Summary of views and trade recommendations. See tables at the end of the report for a brief summary of our macro, FI and FX views for the US, euro area, Sweden and Norway, and a list of trades.
Forecasts. Find comprehensive forecasts here.
Trade highlights:
- Update: Maintain the bullish combo options strategy in Euribor Dec22 (ERZ2). Entered on 22 October.
Rollercoaster ride and a stop-loss parade
Global rates markets are rocked by a rapidly changing monetary policy landscape, mounting inflation pressures, and slowing growth. The past two weeks have seen massive swings in rates, triggering stops that have further exacerbated the market moves. The volatility has been spearheaded by short rates, in which the sell-off culminated last week and was followed by a rebound in the past few days, with markets trimming some of the rate hike expectations.
This week’s decline in short-rate expectations gained some traction from the Reserve Bank of Australia’s softer-than-expected policy statement on Tuesday, in which the bank played down inflation risks and pushed back early rate hike expectations while formally also abandoning the short-end yield target policy. The FOMC meeting on Wednesday was largely a non-event for the rate hike trajectory. Earlier the same day, the ECB’s Lagarde repeated the message from last week’s ECB meeting that “the outlook for inflation over the medium term remains subdued, and thus the three conditions [for rate rises] are very unlikely to be satisfied next year”.
Yesterday, the BoE kept the policy rate unchanged at 0.10%, continuing its asset purchases until the programme expires in December. Economists were split ahead of the meeting while markets were biased for a rate hike. While a December hike is possible, the BoE could prefer to wait for the next Monetary Policy Report in February. When the policy rate reaches 0.50% (possibly before the end of H1 next year), the bank will cease reinvesting maturing assets. Since the BoE will use both the policy rates and the balance sheet to deliver a tighter policy, we believe markets are overestimating the scale of future rate hikes by the BoE (more here).
Diverging views. Amid the turbulence in rates markets, equities have printed new highs, boosted by massive liquidity and strong earnings reports. With 70% of S&P 500 companies now reported, 67% have beaten sales expectations and as many as 83% have exceeded earnings forecasts. As noted by SEB Equity Strategy, stock markets are pricing in a high growth, low inflation environment while bond markets are less upbeat on growth and more concerned about inflation. This discrepancy will likely correct over time, which increases risks of volatility spreading beyond the rates markets.
In the volatility space, implied volatilities in the Treasury market have surged (MOVE index) since September.
The FX market volatility has moved mostly sideways at low levels and recently shown some minor signs turning higher, but the stock market implied volatility (VIX index) is trading near its YTD lows.
Implied volatility: EUR/USD, S&P 500 and Treasury market
In the following, we take a closer look at central banks and inflation expectations. We note that despite high inflation and relatively aggressive near-term Fed expectations, long term policy rate expectations remain very cautious. As discussed below, we expect US rate hike expectations to remain under upward pressure, but mostly for the coming 2 3 years. In the euro area, we foresee potential for long-term expectations to rise while regarding pricing for 2022 as too aggressive, as discussed previously in Euro money market madness, on 22 October.
Fed: Tapering as expected – conditions for rate hikes may be met in H2 2022
On 3 November, the Fed delivered the tapering decision in line with expectations. Asset purchases will be cut back by USD 15bn per month (USD 10bn for Treasuries and USD 5bn for MBS), starting in November and December, with adjustments possible at a later stage if warranted by changes in the economic outlook.
In the statement, the Fed keeps the reference of “transitory factors” but also expresses increased uncertainty, saying that the factors behind elevated inflation are "expected" to be transitory. Progress on vaccinations and “an easing of supply constraints” (new) are expected to support “continued gains in economic activity and employment” (new) as well as a “reduction in inflation” (new). In the press conference, Chair Powell said that the Fed expects supply and inflation problems to ease in Q2 or Q3, meaning that the Fed is preparing for more prolonged inflation pressures well into 2022.
As regards the labour market, Chair Powell expressed optimism about the possibility of a return to the faster job creation and said that that there was a possibility that full employment is reached in the second half of next year.
There was no change in the Fed’s guidance for rate hikes, which means that the Fed still hopes to be able to achieve both maximum employment and inflation temporarily overshooting target before hiking rates. At the press conference, Chair Powell repeatedly said that the Fed is prepared to act on a range of possible outcomes. He did not fight back against current rate hike expectations for the next year, but also did not want to signal that the Fed sees a need to act on currently very elevated inflation.
Fed lift-off in H2 2022 now our main scenario. Altogether, risks of more broad-based and longer-lasting inflation have increased the pressure on the Fed. If employment picks up during the coming months, as we and the Fed expect, the US economy may not be that far from closing the labour market gap. We now expect the Fed to deliver its first hike in H2 2022 and proceed at a slightly faster pace thereafter than earlier expected (read our comprehensive review of the November FOMC meeting here). We will present updated forecasts for the economy and for policy rates in our Nordic Outlook on 16 November.
While our forecast has previously been for the Fed to initiate rate hikes in March 2023, since late spring we have argued that markets are likely to price a high likelihood 70 90%) for lift-off in 2022. However, the scale of the increase in short-rate expectations since September has surprised us. At the same time, rate hike expectations further down the road have remained very muted and have even declined, which has
contributed to long yields rising only modestly during the autumn. We foresee US inflation gaining further pace in the coming months, which means that pressure for even more aggressive market pricing for 2022- 2023 rate hikes seem unavoidable, while we foresee less upside in short-rates forwards further out on the curve.
US rates: Aggressive rate expectations, but primarily for the coming 2 3 years
In the US, forwards are pricing rapid rate hikes, but mostly only for the coming 2 3 years with short rates priced to increase to around 0.55% at end 2022 and 1.30% by end 2023. Only modestly higher short rates are priced thereafter, with the terminal rate peaking at no higher than around 1.75%. In April this year, policy rates were priced to peak at 2.50%. Since then, rate expectations for the coming 1 2 years have
skyrocketed but declined beyond the three-year point. This major shift in the short rate trajectory has been accompanied by the 10y Treasury yield declining from nearly 1.80% at end-March to around 1.55%
currently.
In the euro area, the pricing has been through a rollercoaster with forwards currently pricing an around 15bps increase in the €STR rate to end 2022, around 30bp to end 2023, and a gradual rise thereafter.
Interestingly, in the UK, short rates are priced to peak in 2023 and decline thereafter.
Short rate expectations: 1m OIS forwards
For long yields to rise decisively, markets must price in a higher terminal rate. For this to happen, markets must discount longer-lasting inflation pressures warranting a more extended rate hike cycle, while at the same time remaining positive on the growth outlook.
Rapid rate hikes foreseen pushing inflation back to target. US inflation expectations increased rapidly in September and for most of October, but the past week has seen long-term expectations retreating. Despite inflation being the dominant market theme, US CPI swap forwards discount inflation converging to the Fed’s target over the long term, even though it is priced to remain elevated for longer than previously thought.
CPI swaps, 1y forwards: Current vs. end-August pricing in US and euro area
The fact that US CPI swaps foresee CPI declining to around 2.5% in 2026 helps to explain why markets are not pricing in many additional hikes after 2023 2024. Essentially, the rate hikes priced for the coming 2 3 years are seen as sufficient for pushing inflation towards target (note CPI swaps are for headline CPI, whereas the Fed targets PCE, which tends to be 0.2 0.3pp lower than CPI over the long term).
In the euro area, the shift in inflation expectations over the past two months has been more substantial than in the US, with the whole CPI swap forward curve moving higher but with forward levels still below the ECB’s target.
Gradual rise in US long rates remains our base case. For quite some time, we have been arguing that long rates in the US and Germany are likely to rise only modestly during the autumn, despite increasing inflation pressures. Upward revisions to our US inflation forecast suggest that the risks for markets starting to price a more long-lasting overshooting are increasing. At the same time, however, expectations of early and rapid rate hikes are working in an opposite direction, acting as a drag for long-term inflation expectations and limiting the upside in terminal rate.
We think that inflation pressures and the Fed moving towards hiking rates will continue to add to upside pressure for rate hike expectations for 2022 but especially to 2023 2024. The key point here is that we foresee most of the pressure in the 2023 24 segment of the curve and much more modest rises in rate hike expectations further out on the curve. In such a scenario, we foresee a bear flattening of the US curve in months to come, with only modest increases in long yields. Accordingly, we maintain our end 2021 target of 1.50% for the 10y Treasury yield and 1.80% for mid 2022.
Risk scenarios. A downside risk scenario for long yields in 2022 could involve high inflation triggering even faster Fed hikes, with negative growth effects. In such a scenario, long yields could turn lower in the course of the year after initially increasing. In an upside risk scenario, moderating inflation pressures to mid 2022 could motivate more gradual rate hikes, which together with a more positive growth backdrop could fuel expectations of a slacker but more long-lasting rate-hike cycle, with policy rates peaking at a higher level than in the downside risks scenario. In this scenario, long yields would likely increase next year clearly more than in our base scenario forecast.
US inflation: Accelerating again, adding pressure on the Fed and markets
After US inflation surprised massively on the upside during the spring and early summer, there has been three months with significantly more moderate readings and monthly changes for core CPI almost in line with the pre-pandemic trend. There are, however, reasons to believe that inflation will accelerate again over the next six months. We raise our near-term forecasts: headline CPI is now expected to rise above 6% at the beginning of next year, while core CPI will exceed 5% before base effects start pushing annual inflation lower in April next year. We see several factors contributing to higher inflation.
US CPI: SEB forecast
Prices for used cars will increase markedly again, according to auction prices. Prices for used cars have skyrocketed since spring, adding more than 1pp to annual inflation during the past 2 3 months. After showing signs of slowing, auction prices have shot up even further and with the normal lag this is expected to lift the inflation rate by 0.5pp in November and December.
US: CPI used cars and used car auction prices
Rents inflation is back. Rents slowed considerably during the pandemic, partly due to government actions capping hikes and preventing evictions. A normalisation of rents inflation has been part of our forecast, but larger-than-expected rent hikes in September imply that the normalisation will be more front-loaded than expected. There are also risks that rents will return to the pre-pandemic trend, which would cause the y/y changes to overshoot the underlying trend. This is an upside risk to our forecast.
US: CPI, rents
Rising producer prices spilling to CPI. There are also signs of more underlying price pressures, with a lot of anecdotal evidence of transport problems, difficulties to find labour and price pressures from rising raw material prices. This is likely to trigger further price hikes on CPI prices; rising PPI on consumer goods shows that price pressures are coming closer to being passed onto consumers. A possible mitigating factor is that CPI prices in the current cycle have led PPI prices, which means that parts of the rising producer prices are likely to have already showed up in CPI. Still, there are strong reasons to believe that goods prices will continue to be elevated for an extended period of time.
US: PPI and CPI on core goods
Labour shortages lifting wages. Finally, there are now increasing signs that high demand and labour shortages are leading to higher wages. This means that the inflation rate can be expected to stay high for a longer period of time than predicted previously. As used cars and rents have significantly lower weights in the PCE index, the inflation rate according to the Fed’s preferred inflation measure will accelerate less and be lower. Still, core PCE is expected to rise to 4.5% and stay above 3% for most of next year.
US: Wages and salaries
Altogether, inflation prospects support our view of pressures for even more aggressive rate hike expectations in the coming months.
EUR/USD: Fed supports lower levels
Our short-term fair value model has been heading lower past 28 October and indicated a slight USD
undervaluation after the Fed meeting which, however, seems to be erased on Thursday. Looking at the drivers of our fundamental model, it is the rate spread (EUR-USD) that is behind the move lower in fair value. The risk factor (VIX) is back near post pandemic lows and a normalisation towards higher levels would argue for lower EUR/USD. However, rate spread changes have far greater impact on our fair value model at the
moment and we therefore scrutinize the rate spread factor in a more detailed way below, concluding that the combined effect of underlying rate hike expectations and IRS vs. OIS spread speaks in favour of the 2y USD swap rate rising relative to the corresponding EUR rate in the coming months. For our STFV model this suggest the rates factor should remain supportive for a lower EUR/USD.
EUR/USD vs. Short-term fair value
EUR/USD vs. Rate spread
EUR/USD vs. Risk
Looking at positioning reveals that the fall in EUR/USD past the rate decision could become initially more substantial. This is because there has been a build-up in long EUR/USD contracts between 15 September and 12 October that now should lose support with EUR/USD approaching levels where the long contracts should
be stopped as the average level during that time is 1.1659, i.e. running with an average 0.95% loss already.
EUR/USD speculative positioning – long contracts
Deeper dive into the rates factor in the STFV model: USD 2y swap rate to increase relative to EUR The rates factor in our model is defined as a difference between 2y swap rates in EUR and USD. We foresee prospects for the 2y USD IRS to continue rising relative to its EUR counterpart in months to come (i.e. more negative spread when defined as EUR IRS-USD IRS in the STFV model). Below we decompose the 2y spread to underlying short rate expectations (OIS) and the relative IRS vs. OIS spreads.
Short rate expectations have increased sharply in the US and euro area, but the rise 2y EUR OIS has lagged surprisingly little relative to 2y USD OIS until this week’s correction lower in rate hike expectations. Going forward, we consider it unlikely that Fed expectations would soften relative the ECB.
Short rates: 2y OIS in USD and EUR
This is because we think that the ECB will try to calm down premature rate hike expectations again after recent failed attempts (see No new policy measures, lacklustre attempt by Ms Lagarde to tame rate hike expectations, 28 October). At the same time, the Fed is taking decisive steps toward rate hikes in 2022 which means that we see little prospects for the euro area short rate expectations to rise relative to those of the US for the coming two years. The chart below shows short rate expectations in terms on OIS rates until end 2023.
Policy rate expectations: 1m €STR and USD OIS
USD IRS vs. OIS spread biased to widen vs. EUR. Furthermore, we think that there is potential for the 2y USD IRS vs. OIS spread to rise relative to the corresponding EUR spread. This means that the USD 2y swap rate vs. the corresponding EUR swap rate will likely to rise more than underlying short rate expectations (OIS) alone would suggest. This is because markets are already discounting a drastic reduction in the Eurosystem excess liquidity in 2022 (see Euro money market madness, 22 October), which means that there is less upside in the 2y EUR IRS vs. OIS spread going forward. In the US, however, once the debt ceiling debacle is solved, the Treasury is likely to initiate heavy issuance, initially focusing in T-bills to rebuild the drained cash balance (TGA) at the Fed. The combined effect of heavy issuance, rising TGA balance and Fed tapering should push the USD LOIS, and the spread between the 2y USD IRS and OIS, higher both outright and even more so relative to the EUR.
Swaps vs. policy rate expectations: 2y IRS vs. OIS
In conclusion, we think that the combined effect of underlying rate hike expectations (measured by OIS rates) and relative IRS vs. OIS spreads speak in favour of the 2y USD swap rate rising vs. EUR in the coming months. For our STFV model this suggest the rates factor should remain generally supportive for a lower EUR/USD in the coming months.
Money market monitor
Chart below shows market pricing for short money market rates in terms of OIS 1m, With OIS 1m rate closely related to central banks’ policy rates, OIS forwards can be used as in indication on policy rate changes priced by the markets. For SEK and NOK forward levels are based on our estimates as there is no active OIS market.
Central bank expectations: Cumulative change in overnight rates
Following chart shows market pricing for 3m libor rate levels.
3m libor: History and forwards
Real money value finder
The table below shows yields (YTM) in assorted countries in respective local currency government benchmark bonds and yields from SEK, NOK, DKK, EUR and USD investors’ point of view by accounting for respective currency hedge costs with the aim of providing investors in different domiciles an overview of FX hedged government bond yields. Note that actual relative expected returns over an investment horizon shorter than to maturity will crucially depend on spread movements.
Benchmark bonds: Yield to maturity, local currency and FX hedged
Source: Bloomberg, SEB
Summary of macro, fixed income and currency views
Open trade recommendations
Systematic currency strategies
Closed trade recommendations in 2021
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Olle Holmgren olle.holmgren@seb.se
46850623268
Elisabet Kopelman elisabet.kopelman@seb.se
Karl Steiner karl.steiner@seb.se
46 70 3323104
