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Shaping the Yield Spread According to Policies

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The main pricing criteria of the bond market… Investors prefer to evaluate the developments in the Omicron variant, as well as financial conditions and inflation. Continuing risk sensitivity to expectations of limited impact from Omicron does not seem to undermine risky investment trends, at least. On the other hand, we observe from the soft tone in the US interest rates that there is still no serious tightening and high inflation pricing. Key questions include whether Treasury yields will rise and how much momentum remains in the stock bull market.

 

Financial policy pricing according to maturities… In a world less affected by Covid, it can be expected to have a more pronounced effect on returns, as supply cuts fueled inflation will also accelerate the process of cutting financial incentives. While seeing the movement in the US 10-year bond rate at 1.55%, it will be necessary to look again in a more liquid market. Because a significant part of the investor is still on vacation. This specifically limits the availability of live quotes in the market, so the picture becomes clearer there after a date like January 5th. If we consider what the Fed will do in 2022 and beyond; We see the funding rate as 0.75% in 2022 and 1.5% in 2023, with 3 rate hikes, respectively. We estimate that this rate will reach 2% in 2024 and 2.5% in 2025. On the T-Bond and LIBOR side, we will watch higher levels brought about by the increases in the funding rate in similar time periods. In this context, a movement of 2% to 2.5% as of 2023 and above 3% by 2025 can be expected in the 10-year yield side.

 

US – German 10-year bond interest spread. Source: Bloomberg

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Interest spreads… The economic power of the US and the possibility of crisis are less than Europe and China. This creates an expectation that there will be stronger confidence in policy evolution and that interest rates may rise faster. As the Fed begins to cut back on its bond purchases and is expected to raise interest rates from the second half of next year, the yield spread will broadly open in favor of the US. We believe that monetary policy differences will become more important in this period.

 

While the ECB certainly paid attention to accelerating inflation trends in the region, it expressed less concern about inflation pressures. In fact, Lagarde recently said that the central bank expects Eurozone inflation to eventually decline and “if we had any tightening approach to the current situation, it would actually do more harm than good.” This builds on the expectation that the ECB will only very gradually reduce its total bond purchases in 2022. We do not currently expect an ECB rate hike for 2022. This divergence between the outlook for ECB policy and a faster-moving Fed allows us to envision a wider US-German yield spread.

 

Conclusion? The interest spread will move within the framework of the differences in crisis potentials between countries, the degree of prudence in monetary policy, the faster tightening trend of the Fed and different layers of inflation. In the current outlook, we expect long-term interest rates to widen the difference again, in the yield curve trend that emerges with the convergence of short-term interest rates to long-term interest rates in the US. We think that this may be due to a more permanent inflation concern. Therefore, the Manavgat escort movement in different maturities will depend on the weighting of the views that “inflation will eventually return to normal” or “may become permanent and structural”. It didn’t follow for a while as the market thought the Fed was moving fast, which explains why and how the 10-year yields stayed at 1.40%.

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