Do you remember the last ECB rate hike, over 10 years ago?
The time was July 2011. Despite the eurozone debt crisis, Jean-Claude Trichet raised the ECB’s key rate to 1.50%. He needed to combat inflation, which was dangerously close to... 2.50%. We all know what followed, traumatising many a bond investor facing deflation in Europe and the debt crisis in the weaker European nations.
Eleven years later, it is difficult not to compare the scenarios. Christine Lagarde, who succeeded Mario Draghi, is once again faced with the dilemma of fighting inflation while at the same time preserving financial stability. Although the ECB has consistently revised its inflation forecasts upwards, it is falling behind events. Faced with annual price growth above 8%, the CB is preparing the markets for an initial rate hike in July, with at least two more likely before the end of the year.
The deposit rate could thus come out of negative territory and rise from -0.50% to +0.50%.
This tightening cycle, which has been widely anticipated by the rates markets, could nevertheless amplify the change we are experiencing in the bond markets, one marked by rising yields and increased volatility on the financial markets. What are the consequences for investors?
A flatter curve
The inflation outlook is likely to remain high in the coming months, leading the ECB to revise its inflation expectations upwards in June. This supports a faster and stronger reaction by the ECB in terms of rate hikes in 2022. In this environment, short yields should remain under pressure while the upward movement on the 10-year portion could be more limited, taking into account the negative effects on growth of the ECB's more restrictive policy. The flattening of the Euro curve should therefore become more pronounced in the months to come, particularly in the event of a proven slowdown in activity.
An increase in prices changes the behaviour of economic agents and distributes their income differently according to their perception of the situation. Worried consumers initially speed up their purchases and renegotiate their wages. Companies raise prices in response to rising costs, to protect margins. However, not all companies have the opportunity to pass on this increase. In the face of this inflationary pressure and monetary tightening, dispersion is likely to increase. The upcoming quarterly results season should highlight these differences, justifying a high degree of selectivity in the credit market.
So how should we prepare for this rate hike cycle?
Favour variable rates
The coupon on floating rate bonds is reset regularly based on a reference rate (typically the three-month interbank rate), plus a credit spread determined by the market. Investors are therefore naturally protected against rising rates.
Today, we consider an average credit premium of close to 120 basis points to be realistic. If we consider that short rates exceed 1%, such a strategy should pay off.
Moreover, the evolution of floating rate bonds is negatively correlated with the yield on sovereign bonds. They thus offer a good diversification opportunity for a bond portfolio.
Coupons indexed to inflation offer real protection
With inflation figures expected to continue to exceed expectations in Europe over the coming months, and inflationary pressures increasing (commodity prices, deglobalisation, supply chain issues, etc.) we view inflation-linked bonds as an attractive investment vehicle to protect against the risk of inflation surprises. After the recent drop in inflation expectations, we believe these bonds are a relevant alternative to nominal bonds, especially on the short end of the curve. The inflation that may accumulate in the coming months thus offers a significant protection against a rise in real rates.
Flexibility and active management for your bond portfolio
The inflation theme has indeed made a comeback! We expect it will continue to preoccupy the financial markets in the coming months. It could even increase as a result of the Russian oil embargo and a probable reduction in gas supplies in Europe. The impact of monetary tightening on economic growth is likely to be more noticeable in the second half of the year In this context, we believe the best solution for any bond investor will be to adopt an active and flexible style of management.