Higher volatility and risk premium at the front end of developed market interest rate curves constitute a regime shift, but are not an impediment for the growth outlook.

The market has priced a regime shift from a world where inflation risks were one-sided and central banks could control both the front end and long end of curves, to one where inflation risks are to the upside, and risk premium must be built for sharper hiking cycles.

This regime shift has been playing out over the month, but last week's moves were acute even in the context of recent volatility.

The largest moves were in front end interest rates, with multi-standard deviation selloffs in Canadian front-end rates, following a hawkish Bank of Canada, and Australian 2y bond yields, which had two consecutive 5+ standard deviation daily moves higher after a higher than expected CPI print was followed by the RBA failing to defend its yield curve control target in the bond market. European 1y1y interest rates rose by 17bps (2.8 weekly stdev move), and the 10s-30s curve flattened following a tepid defense of forward guidance by President Lagarde during the ECB press conference. In the US, the market brought forward rate hikes, resulting in a significant flattening of the curve for shorter dates, most notably Dec 22 vs Dec 26 eurodollars flattened by 29 bps.

In emerging markets, 2y vs 10y curves flattened by ~25 bps in Poland and South Africa driven by higher CPI prints in Poland and the broad flattening of global yield curves. In Brazil Jan 23 DI yields rose by 115bps on the week (2 weekly stdev), due to heightened fiscal risks at a time when global liquidity conditions are worsening. The 150bp rate hike on Wednesday from the BCB was below market pricing of a 175 bp hike and was not sufficient to prevent additional selloffs in Brazilian fixed income assets.

The velocity of the moves higher in interest rates constituted a VAR shock for short term interest rate markets. Liquidity was impaired, and market price action suggests large, forced position stop outs. Noise in the market is high, and at times like this, it is important to focus on what happened, the meaningful changes to the macro outlook, and resulting structural changes to our view.

What happened and what’s changed?

At its essence, what has happened in higher beta developed market rates markets (NZD, GBP, AUD, CAD) over the last 6 weeks is what has already happened in emerging markets this year. Central Banks have delayed tightening due to a belief in the transitory nature of inflation, falling behind the curve, and then subsequently capitulating. Risk premium increases, both as a function of rising inflation and as a function of the central bank being behind the curve and having to subsequently change course.

This capitulation in the face of rising inflation has significantly damaged the efficacy of forward guidance as a policy tool, both in fact and in the minds of market participants. It takes a long time to build trust, but an instant to destroy it. Like the Fed’s wavering on FAIT in June, portfolio positioning that reflected the forward guidance of the RBA would have resulted in severe losses this week.

Forward guidance was the tool used to control the front end of yield curves. If its efficacy has fallen and inflation remains elevated, then risk premium and volatility should move higher structurally until central banks anchor the front end with credible hiking cycles. This is a significant change.

Where to from here?

October played out largely as we have been highlighting throughout this year. Inflation is rising, inflationary environments are more volatile in aggregate, and the market may need to price DM central banks being behind the curve.

However, it is important to recognize that the market is pricing an appropriate increase in risk premium for sharper and steeper hiking cycles driven by rising inflation. This is not the same as a delivered counter-cyclical hiking cycle, where real yields are tightening sharply as central banks move ahead of inflation. In fact, real yields remain deeply negative and moved more negative this month and financial conditions remain easy. While there are clear risks to growth, there are also signs of strength, especially in the US. Corporate earnings were at record highs and household balance sheets are exceptionally strong.

Therefore, our view remains that despite the moves we have seen in the front end, the outlook for growth is still reasonably positive and cyclical assets can perform. We continue to be short US front end rates, paid Poland rates and in flatteners in EM to reflect our view on global interest rate risk premium but we also continue to like holding equity exposure and longs in the front end of high carry frontier countries. Finally, the volatility of recent weeks does open up idiosyncratic opportunities and we will be looking to add to those exposures as volatility falls.

COVID Pandemic

Globally, COVID cases increased last week for the second week in a row, with cases rising in Europe and CEEMEA while falling in Asia, Latin America, and the US. While cases continued to fall in most countries in Asia, Chinese cases increased over the last week, with multiple cities in China’s Inner Mongolia region facing travel lockdowns. In the CEEMA region, cases in Russia continued to rise over the last week to the highest levels since the beginning of the pandemic in Russia -- an increase that has led to an eleven-day shutdown of non-essential services in Moscow. Finally, in Latin America, COVID cases continued to fall across much of the region, although cases continued to move higher in Chile over the last week.

In Europe, COVID cases increased at an elevated pace of +25% for the week, with case growth remaining elevated in Central and Eastern Europe and broadening across Western Europe. Weekly case growth in countries such as Poland, Hungary, and the Czech Republic ranged from +70% to +101% for the week, while Germany, France, Italy, and Spain saw cases rise between +5% and +38% for the week. Increasingly, the elevated COVID waves are challenging policymakers in the most impacted CEE countries. For instance, in Poland on Monday, Health Minister Adam Niedzielski was quoted saying the government would need to consider tighter COVID measures if cases averaged over 7,000 cases per day -- on Saturday, Poland recorded 9,806 cases.

While COVID cases fell slightly last week in the US, test positivity rates increased slightly to 5.0% from 4.8%. Furthermore, in contrast with the benign outlook over the two months, some leading US data we track has begun to show more mixed signs, with wastewater positivity data in Colorado, Connecticut, and Massachusetts moving higher over the last week. While the near-term services recovery appears supported in the US due to still falling levels of US COVID concern, elevated vaccination rates, and US policymakers who are reluctant to reinstate COVID measures, the risks are rising around a renewed national or regional US COVID wave.

Calvion’s View: The key COVID theme for the last week was the continued rise in cases in Europe, with a focus on the significant and increasingly disruptive COVID outbreaks in poorly vaccinated parts of Central and Eastern Europe. While we generally remain constructive the economic impacts from the COVID outlook on the back of higher vaccination levels and changed policymaker incentives, we are closely monitoring the rising European COVID wave and the potential risks it poses as the colder winter season approaches. In Asia, we remain positive on the continued recovery from Delta waves in Southeast Asia, although we continue to see tail-risks from China’s strict zero-tolerance COVID approach.