Debt crisis or new interest rate cycle?

The bad omens for the eurozone’s public debt are returning, reminding us of the euro crisis that almost caused its disappearance in 2010-2012. Unjustified fear or objective risk motivated by data?

The bullish environment for the yields that the market demands for government bond issuances is bringing tensions to the fixed income markets. Rising inflation driven by energy costs has meant that boththe European Central Bank (ECB) and the Federal Reserve (Fed) have had to raise their official rates. The Fed’s 25 basis point hike (federal funds between 3.75% and 4.00%) was the first in three years and signaled further tightening of monetary policy. The message was more hawkish than the hike itself: 16 of the 18 participants who submitted their forecasts expect at least one more hike this year and President Kevin Warsh said inflation has been too high for too long and that this summer’s data does not show a significant improvement in underlying trends.

After the meeting, markets priced in an 87% chance of at least one more hike this year and US Treasury yields rose in response (their prices, always in reverse, fell), led by shorter maturities and with the 10-year Treasury closing above 5% for the first time since 2007. This is a difficult context for investors who bet on a relaxation of yield curves and for our monetary authorities.

In Europe, France is the most feared

Among the mountains of debt that surround European countries is the fiscal crisis that the eurozone’s second largest economy is going through and the upward path of its public debt that do not bode well. Meanwhile, the country’s political instability prevents a budgetary adjustment that is essential at this time to show fiscal discipline to reduce the cost of French state emissions. What’s more, a downgrade could come at any time and complicate things further at a time when the risk premium on French debt means that the French bond is more than 100 basis points higher than the yield of its German equivalent (twice as much as the Spanish one, who would have thought it not many years ago!).

There is not going to be a fiscal crisis like the one 15 years ago

I think it is better to be categorical and not create unjustified fears: the environment of the crisis we suffered 15 years ago was very different from the current one. At the time, the institutional design of the Eurozone was incomplete as it lacked a centralised fiscal union and a single treasury. In addition, the bursting of the housing bubble and the 2008 financial crisis in the United States weakened European banks and created bubbles in the price of many assets that burst easily due to the illiquidity of the market and caused bailouts that escalated tension: countries such as Spain and Ireland suffered banking crises due to excessive private credit and state bailouts drastically increased public debt. It is true that in recent months, concern about European public debt and deficit levels has increased significantly. But I think that’s not what’s discounting the bond market strain.

Now, I insist, leaving aside doomsayers, the environment is very different and I believe that the world bond markets are not discounting a fiscal crisis but a new cycle of rate hikes that, as the facts show, has already begun. One thing is the headlines and another is the solid economic background of the global economy.

Will the hikes in official rates continue?

This will most likely be the case and we will have higher official interest rates over the coming months: rising inflation, solid growth in the global economy and geopolitical movements driving up energy prices are factors that are not going away anytime soon. Importantly, resilient economic growth is playing a key role in this, allowing central banks room to raise rates without derailing the expansion.

Implications for investment in markets

Given that the markets are already pricing in more hikes than the Fed itself had anticipated (similar in Europe with the ECB), it is advisable to keep fixed income in portfolios in short maturities and with an opportunistic approach when it comes to increasing duration in the event of a new rate hike; I expect a stabilization of the yield curve at current levels, although the political scenario in Europe is not going to help. In practice, this means, as I say, focusing on investments linked to short-term and, where appropriate, medium-term rates in the scenario discussed in order to obtain the carry (intrinsic return of fixed income via coupons) and, without a doubt, taking advantage of the floating coupon bonds that I have insisted on so much in this column.