Summary

1.Central banks are still front and center. Policy rate hikes of 75 bps are no longer the norm. Smaller increases are still to come. We expect end of cycle rates in Q1 2023, 5% for the Fed and 2.75% for the ECB deposit rate.

2.2023 in two steps: long-term rates are expected to rise in Q1 in Germany and the US as private investors will have to absorb a deluge of new issuance in the eurozone. Long-term rates should then ease as inflation risk is reduced and investors will focus on recession risk and the timing of future central bank rate cuts.

3.Tactically, German and US government bonds are close to the overbought zone. Strategically, we remain Positive on US government bonds and Neutral on German government bonds. Our targets for 10-year bond yields are 3.5% in the US and 2.5% in Germany in 12 months.

4.Unpredictable BoJ:  after surprising investors in December 2022 by raising the 10-year rate fluctuation ceiling to 0.5%, the Bank of Japan (BoJ) surprised again by not continuing in this direction in January. The impacts are significant, not only on Japanese rates and the yen, but also on foreign assets in turn. We believe that long-term Japan government bonds may continue to face selling pressure as expectations of monetary policy normalisation are strong. The BoJ will raise the 10-year rate ceiling to 1% on March 10 in our view.

5.Strategically, fixed income opportunities. We are Positive on US Treasuries and US Investment Grade (IG) corporates. We are Neutral on eurozone IG corporate bonds. We prefer subordinated bonds in the eurozone. In relative terms, IG corporate bonds are more attractive than High Yield bonds. We are positive on emerging market bonds in hard currency and local currency.

Central banks

Smaller rate hikes but hawkish tone

European Central Bank (ECB)

ECB credo: “Hit and stay”, i.e., raise rates and keep them high.

Inflation too high: 9.2% year-over-year in December and the ECB fears future wage increases. It expects inflation to be above its 2% target in 2023, 2024 and even 2025.

Reliable forecasts? Probably not because no one can predict inflation over this horizon. Plus, national central banks have contributed to this result, and some rely on non-model judgments. In any case, what’s important is not the figure but the signal the ECB is sending. By posting inflation above 2% in 2025, the ECB is affirming its desire to raise rates further.

Our expectations: we are more confident than the ECB about the future fall in inflation. We expect the ECB to hike rates by 50bps in February and 25bps in March. We see the end of cycle deposit rate at 2.75%. We do not expect any rate cuts this year.

US Federal Reserve (Fed)

Federal Reserve Credo: “Higher for longer”, i.e., raising rates and keeping them high.

Inflation: third consecutive monthly fall. The trend seems well underway, although inflation is still too high.

Less pressure from politicians and the media: some call the Fed to prioritise maximum employment now that the fight against inflation is being won.

25 or 50? The Fed should continue to reduce the size of its rate hikes as we approach the end of cycle rate. We are looking for a 25 bp increase in February. The likelihood of it doing 50 is not excluded however, this would be a way to tighten the financial conditions that have largely (too much?) loosened in January.

Our expectations: we see an end of cycle rate of 5%, reached in Q1, followed by a long pause and 50 bps rate cut in Q1 2024.

Investment Conclusion

The end of the monetary tightening cycle is near in our view. The Fed is expected to end its cycle with a policy rate of 5% in March and the ECB with a deposit rate of 2.75%. The inflation trajectory and financial conditions are probably the two most important indicators to follow. These two central banks should then keep rates at these levels to prevent inflation from returning and financial conditions from loosening too much. We expect rate cuts in 2024 to respond to the decline in economic growth.

Bond yields

Still very volatile

December 2022: Higher long-term rates in Germany and the United States following the aggressive rhetoric of central bankers and the reopening of the Chinese economy.

January 2023: Reversal of this trend thanks to the deceleration of inflation and disappointing statistics (consumption, US real estate…), which suggest that the Fed could relax its speech.

Our expectations for Q1: Higher long-term rates as 1/they have fallen to levels close to oversold territory, 2/appear too decorrelated from fundamentals and 3/a deluge of bond issuance is expected (net supply of 601 billion euros in the euro zone). This time, as central banks have ended their net purchase programs, the new bond supply will have to be absorbed by private investors only.

Our mid-end 2023 expectations: Lower long-term rates compared to Q1 levels as concerns about inflation will have faded and investors will focus on recession risk and future central banks rate cuts.

Investment Conclusion

Sizeable Q1 issuance volumes are expected to push long-term interest rates higher in Q1. The trend should then reverse as investors focus on the risk of recession and the timing of future central banks rate cuts. Tactically, current long-term rates seem too low. Strategically, we remain Positive on US government bonds and Neutral on German government bonds. Our targets for 10-year bond yields are 3.5% in the US and 2.5% in Germany in 12 months.

Theme in Focus

Don’t fight the BoJ

Alone: while all the world's central banks were rapidly raising rates last year, the Bank of Japan (BoJ) did nothing. Its policy rate has remained unchanged at -0.1% since 2016 and it has continued to intervene to prevent the 10-year rate from rising above 0.25%.

New backdrop: inflation has started to return in Japan and the yen fell to extremely low levels in Q4 2022 (USDJPY climbed beyond 150) due to interest rate differentials.

Surprises in December! As in 1989, when the BoJ raised rates on Christmas Day, it surprised markets in December 2022 by raising the 10-year rate ceiling to 0.50%, citing the need to improve the functioning of the bond market. Indeed, the BoJ holds more than 50% of Japan's outstanding government bonds (JGBs). This decision was seen as a first step towards a less accommodative monetary policy.

Immediate impacts: the yen jumped, bond yields moved up and negative-yielding bonds almost disappeared in Japan.

Longer-term impact: Japanese investors were traditionally large buyers of foreign assets, especially US Treasuries. This trend has reversed as 1/Japanese yields are a little bit more attractive today and 2/the cost of hedging USD/JPY is very expensive. As a result, the downward pressure on foreign yields, especially US yields, is structurally a little less strong than before. In addition, the role of the yen in carry trades could be questioned if the BoJ turns more hawkish.

January 2023, surprise! The BoJ did not raise the 10-year rate ceiling at the January meeting despite expectations but tweaked its fund provision to better control the yield curve. We believe that long-term JGBs may continue to face selling pressure as expectations of monetary policy normalisation are strong. The BoJ will raise the 10-year rate ceiling to 1% on March 10 in our view.