The latest inflation data releases both in the US and the euro area have shown that the rate of increase of prices of goods and services declined during the months of November and December, respectively. In fact, the rate of inflation in the US declined to 7.1% in November compared to 7.7% in October, with the rate of inflation declining to 9.2% during the month of December in the euro area compared to 10.1% during the prior month.

However, while the recent pullback in inflation is welcome news, it is not enough to persuade both the Federal Reserve and the European Central Bank to move away from their current path of further interest rates increases. The rate of inflation is still above levels that are acceptable, with a sustained and marked decline in inflation needed before either central bank adopts a more dovish approach.

While central banks may be adamant on continuing with the current trajectory of raising rates and curtailing bond purchases, financial markets have interpreted the latest economic data releases in such a way that central banks may slow down or even revert from their current stance.

In fact, both sovereign and corporate bonds have rallied in recent weeks, resulting in a decline in yields on both sides of the Atlantic. However, the lower yields may be temporary, with forecasts by Goldman Sachs showing that the yield on the US Treasury is expected to peak at 4.25% (currently at 3.53%) during the third quarter of the current year, with the yield on the German bund expected to reach 2.75% (currently at 2.17%) during the current quarter, after which it is expected to stabilise at that level for the remainder of the year.

The higher yields are expected to be driven by several factors.

In the US, the Federal Reserve is expected to raise rates by a further 25 basis points at its next meeting. Other factors include a tight labour market, with the rate of unemployment remaining stubbornly low at 3.7% as the US economy is still able to produce new jobs despite the downward trajectory in new jobs created in recent months. Furthermore, the recently published Federal Open Market Committee minutes showed that members were not expecting a cut in rates in 2023 even if the rate of unemployment is expected to increase.

In the euro area, the projected higher yields are expected to be driven by monetary policy as the ECB has more ground to cover than the Federal Reserve. The ECB’s recent announcement that it would be ending its bond purchases altogether in March is also expected to contribute to higher yields.

Moreover, given the rise in energy prices following the outbreak of the war in Ukraine, the expectations of higher bond issuance by European governments to assist households in lowering their energy costs is also expected to result in the higher sovereign bond yields, according to Goldman Sachs. However, it should be noted that the milder than expected weather in Europe may lead to less sovereign bond issuance as households may require less government support.

As a result, the spread on offer between the German bund and other European 10-year paper is expected to widen, with the more susceptible economies expected to widen even further.

With respect to the corporate bond market, which is not only influenced by the fundamentals of the underlying business but also by monetary policy decisions and economic forces, the spread between corporate bonds and sovereign bonds is expected to widen further during the current quarter, after which spreads are expected to tighten as market conditions improve.

The general view among investors is to seek safety in high-quality corporate bonds

Given the consensus of a worsening global economy together with tighter monetary policy conditions, the general view among investors is to seek safety in high-quality corporate bonds, notably investment grade corporate bonds, which typically have the fundamental characteristics that allow them to withstand the expected worsening economic conditions in the coming months.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.

Simon Gauci Borda is a research analyst at Curmi and Partners Ltd.