Summary

1. Central banks are still front and center. The Fed, ECB and Bank of England have all raised interest rates as expected. Moreover, they have all indicated that there would be a few more hikes to come, but suggested that the tightening cycle was almost over, and rates were likely to stay at restrictive levels for some time. The Fed is expected to end its tightening cycle with a key rate of 5% in March (our estimate) and the ECB should end with a deposit rate of 3.25% in May. We do not see any rate cuts this year.

2 .Evolution of long-term rates: we expect long-term rates to rise in the coming months before falling in the second half of the year. Our 12-month target for 10-year bond yields is 3.5% in the US and 2.5% in Germany. Strategically, we remain Positive on US government bonds and Neutral on German government bonds.

3. The unnecessary stress of the American debt ceiling: once again the legal debt limit has been reached in the US. The Treasury has put in place extraordinary measures to curb spending, so that it can continue to operate until June or even August. Beyond, it can only rely on its cash balance and tax revenues to repay maturing bonds. The most visible effect on the markets is the surge in the 1-year CDS. The consequences for rates and the level of market liquidity are less visible for now. Money market rates could rise in Q4. In the past, a political compromise has always been found to avoid a default on the country's debt.

4. Strategically, opportunities in Fixed Income. We are positive on US Treasury bonds and US IG corporate bonds. We have moved from Neutral to Positive in Euro IG corporate bonds. In relative terms, IG corporate bonds are more attractive than High Yield bonds. We are Positive on Emerging Market bonds in hard currency and in local currency.

Central banks

The beginning of the end

European Central Bank (ECB)

A more balanced tone in the February meeting, contrasting with the aggressive tone at the previous meeting. Inflation is still too high, but the ECB concedes that it is falling.

Further rate hikes ahead: the ECB has pre-announced a hike of 50 basis points (bps) for the March meeting. The rest will depend on future economic data.

Our expectations: the 50bps increase to be made at the March meeting should be accompanied by a more dovish tone thanks to more favourable economic projections (return of inflation close to the 2% target in the medium term thanks to lower energy prices). This will pave the way for a final (reduced) cut of 25bps in May and an end-of-cycle rate of 3.25% in our view.

Rate cut(s)? Not on the cards this year, in our view. The ECB will have to keep interest rates restrictive to avoid a resurgence of inflation and expected inflation.

US Federal Reserve (Fed)

A more balanced tone accompanied by a smaller cut (25bps) at the February meeting. The Fed recognizes that disinflation has begun but that its job is not over. Wage pressures remain high. Financial conditions have eased considerably. They have returned to the same level as in March 2022 when the Fed started its monetary tightening cycle.

Our expectations: the healthy labour market does not necessarily mean additional rate hikes, but it postpones the date of the first rate cut, in our view. The market is seeing things differently: expectations of rate hikes have risen by 25bps and the timing of the first rate cut has barely changed. We expect the final rate hike of 25bps in March, which would take the end-of-cycle rate to 5%.

Rate cut(s)? Not on the cards this year, in our view. The Fed will have to keep interest rates restrictive to avoid a resurgence of inflation and expected inflation.

Investment Conclusion

The major central banks (Fed, ECB and Bank of England) have all raised interest rates as expected. Moreover, they have all indicated that there would be a few more hikes to come, but suggested that the tightening cycle was almost over, and rates were likely to stay at restrictive levels for some time. The Fed is expected to end its tightening cycle with a key rate of 5% in March (our estimate) and the ECB should end with a deposit rate of 3.25% in May. We do not see any rate cuts this year.

Bond yields

Lower volatility

Long-term rates temporarily collapsed after the Fed and ECB meetings in early February. Many market participants had taken short positions and were caught off guard when long-term rates started to fall following non-hawkish speeches by central bankers, thus forcing them to buy back their positions, pushing rates even lower.

This movement reversed the following day after the publication of very strong figures for both US employment and the Services sector activity.

We expect higher long-term rates in the coming months due to still high inflation, a robust US labour market and a flood of new issuance to be made in the eurozone as the ECB follows in the footsteps of the Fed by reducing reinvestment of maturing bonds.

Beyond, long-term rates could fall as inflation tails off and central banks become more accommodative in the context of slowing economic growth.

Investment Conclusion

We expect long-term rates to rise in the coming months before falling in the second half of the year. Our 12-month target for 10-year bond yields is 3.5% in the US and 2.5% in Germany. Tactically, long-term rates seem too low at current levels. Strategically, we remain Positive on US government bonds and Neutral on German government bonds. 

Theme in Focus

The unnecessary stress of the US debt ceiling

Debt ceiling (USD 31,400 bn) reached on 19 January: Congress must approve an increase or a suspension of the ceiling, without which the Treasury cannot issue new debt. The ultimate risk is that they cannot repay maturing bonds. This would lead to a default.

Risk of upsetting the issuance schedule of Treasury bonds: since 19 January the Treasury has suspended certain payments in order to delay the date of default. Once these extraordinary measures have been used up (by June or even August according to some estimates), the Treasury will no longer be able to raise funds to finance deficits. It will only be able to rely on the balance of the Treasury General Account (TGA), the government’s current account and on tax revenues for April and September to continue its activity.

Immediate consequence 1: the cost of insuring a 1 million dollar bond against the risk of default within 1 year (Credit Default Swap, CDS) in the US soared to 5,000 dollars, from 1,200 dollars in mid-January.

Immediate consequence 2: when the TGA balance drops, bank reserves rise, which amounts to injecting liquidity into the system. This is the opposite effect that the Fed is seeking to do with its Quantitative Tightening (reduction of the Fed’s balance sheet).  A USD 500 billion TGA reduction is equivalent to cancelling just over 5 months of QT.

Short-term consequence: once Congress has found a solution (in our view between August and November), the Treasury will need to shore up its cash position (the TGA). This will entail two things i) a very sharp increase in Treasury bill issuance and ii) a decrease in bank reserves and therefore a withdrawal of liquidity from the system this time, which will be amplified by the Fed's QT. A liquidity squeeze, combined with significant net debt issuance in Q4, should push up money market rates.

What is the lesson of raising the debt ceiling 78 times since 1960? A political compromise has always been found, sometimes at the last minute, because the stakes are far too high. Although in the short term, turbulence can occur, in the medium term, financial markets in the past have been largely unscathed by these political squabbles.

Investment Conclusion

Once again, the legal debt limit has been reached in the US. The Treasury has put in place extraordinary measures to curb spending, so that it can continue to operate until June or even August. Beyond that, it will only be able to rely on its cash balance and tax revenues to repay maturing bonds. The most visible effect on the markets is the surge in the 1-year CDS. The consequences for rates and the level of market liquidity are less visible for now. Money market rates could rise in Q4. In the past, a political compromise has always been found to avoid a default on the country's debt.