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Fixed Income Perspectives January 2022

Quarterly macro and market insights from Capital Group’s fixed income team

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Moderating global growth as policymakers grapple with persistent inflation

Global economic growth looks likely to continue in 2022, albeit at a more modest pace. The COVID-19 pandemic does, however, add uncertainty to the outlook, as evidenced by the recent emergence of the Omicron variant.

Omicron’s higher transmissibility and infection rates have affected both supply chains and labour markets across the globe. That said, current hospitalisation and death rates appear to be significantly lower than was witnessed earlier in the pandemic. The economic impact of this variant may, therefore, be relatively modest and short-lived.

Several major central banks are now tightening monetary policy. Pandemic-related supply disruptions combined with strong demand for goods are creating inflationary pressure that is more sustained than had been expected.

The rapid pace of growth is widely expected to moderate in 2022

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As at 31 October 2021. Source: Bloomberg economists consensus estimates

Headline inflation in the US surged to a near 40-year high as the Consumer Price Index hit 7.0% in December 2021. Five-year break-even inflation rates were close to 3% at year-end 2021, having started the year near 2%. This rate indicates the average inflation required over the life of a bond for TIPS and nominal US Treasuries to generate the same total returns and, therefore, is indicative of the level of inflation that US bond markets are pricing in through 2026.

Expectations around future interest rate hikes have changed dramatically. Among both US Federal Reserve (Fed) policymakers and market participants, there’s been growing recognition that uncomfortably high inflation — well above the Fed’s 2% core personal consumption expenditure target — may persist throughout 2022.

The Fed conceded that inflation may not be as transitory as it anticipated. Indeed, in response to a question about his persistent use of the term “transitory” in earlier statements, Fed Chair Jerome Powell said: “It’s probably a good time to retire that word.” In December 2021, the Fed said it would double the speed of tapering, which began the month before. This quicker reduction in its bond buying puts the Fed on track to end its purchases in March 2022.

US financial conditions are very loose, but that may change soon

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Metric for US financial conditions compiled by Goldman Sachs (from various measures, including the level of interest rates and the strength of the US dollar) through December 2021. Source: Goldman Sachs

The Fed’s dot plot indicates three hikes in 2022 — each one a quarter-point followed by the same increase in 2023. Market pricing for fed funds-related futures contracts did not initially adjust to reflect this accelerated timeline for interest rate hikes. This disconnect, which may well be seen again, could indicate market participants are weighing how tightening financial conditions affect economic activity and, by implication, Fed policy.

US financial conditions remain historically loose, though they should tighten as economic momentum from the strong rebound of 2021 fades and central bank policy support diminishes. Beyond tighter monetary policy, pandemic-related economic friction in the US and other economies could lead to slower than expected global growth.

Inflation hit new multiyear highs in the US, UK and eurozone

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*Flash estimate by Eurostat, the statistical office of the European Union. Latest available month-end data for the US and eurozone (December 2021) and the UK and Japan (November 2021). Source: Bloomberg

The European Central Bank will likely lag the Fed’s actions around tapering and rate hikes. Infection rates and illness due to the Omicron variant increased in Europe earlier than in North America. Several European governments reversed course on their relaxation of restrictions. Limitations were placed on businesses and social gatherings, including vaccination status-related measures.


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