Global Fixed Income Bulletin
October 31, 2023
October 31, 2023
Another October Shocker: Déjà Vu?
October 31, 2023
October was another challenging month for global fixed income assets, as yields continued to rise (curves “bear steepened” with the long end rising faster than the short end), spreads widened, and the dollar strengthened. As war broke out in the Middle East and economic data remained resilient in the U.S., and inflation remained sticky across the globe, it was evident that rates were to remain higher for longer. The 10-year interest rate rose 36 basis points (bps) in the U.S., 18 bps in Japan, 25 bps in New Zealand, and 44 bps in Australia. Yields in the emerging markets also continued their ascent as most countries fixed their sights on what was happening in the U.S. The longer it takes for the U.S. economy to slow and the dollar to weaken, the harder it is for emerging market assets to rebound and global growth to outperform the U.S. Also, the onset of the war in the Middle East increased volatility within the fixed income sector and added uncertainty to an already difficult landscape. Credit spreads were mostly wider over the month for many of the same reasons (e.g., resilient U.S. economy, continuing inflation, hawkish central banks, higher rates, war in the Middle East, etc.) with high yield underperforming investment grade. Securitized credit was mixed over the month, but the trend was to slightly wider spreads. Within FX, the U.S. Dollar (USD) continued to strengthen against most currencies.
Fixed Income Outlook
Fixed income markets remain challenging with inverted yield curves, bear steepening, and volatile price action all making it difficult to have a high degree of confidence about what will come in 2024. What we do know is that growth has been strong in the U.S. and weak outside it, generally speaking. This economic strength has been the reason for poor global financial returns in Q3, in our view. More specifically, September’s poor financial market performance continued in October. U.S. Treasury 10-year real yields rose another 29 bps in October, driving poor asset market performance across the risk spectrum. In many ways, the reaction of bond and equity markets was understandable. After credit markets did not react much to the September U.S. Treasury market sell off, very strong October data releases (which began with the early October gangbuster employment report and finished with the extremely strong Q3 GDP report) could not be absorbed as worries of a hard landing widened credit spreads materially. In other words, there was only so much “good” news credit markets could take.
While good economic news would probably be “good” news in normal times for credit and equity markets, it was not in October. With inflation still well above target and looking like it might get a little sticky in the months ahead, news that the U.S. economy continued to accelerate well above trend portended ever higher interest rates. The consequences of the sell-off in stocks and bonds was a material tightening of financial conditions, unwinding optimism earlier in the year when it was thought the economy would slow sufficiently to avoid sell-offs in equity and rates markets.
One of the key developments which put an end to the Q3 bear market were comments by Fed officials, including Fed Chairman Jerome Powell, both prior to and after the November FOMC meeting expressing concern that financial conditions were tightening too much. The comments served to jeopardize the probability of the ever-elusive soft-landing scenario (e.g., lower inflation, no recession) which the Fed has fervently hoped for.
One of the most interesting aspects of the bond market sell-off was its bear steepening, with long rates rising faster than short rates, which left us with a few primary observations. First, with growth strong, there was upward pressure on real rates (as noted above). Second, the U.S. government is running very large deficits given the strength of the economy, adding bond supply to a market already saturated with U.S. Treasuries. Indeed, three of the largest buyers of Treasuries have either vanished or significantly reduced their appetite: The Fed is doing quantitative tightening (QT); banks are losing reserves or have large mark-to-mark losses on security portfolios, and foreign official institutions are less active given the bear market in rates. Lastly, Fed comments suggested a lack of willingness to commit to further rate hikes, even if another one was shown in the dot plot. A lack of commitment to hike rates in the face of too high inflation suggests a lack of desire to “over-tighten” policy, subordinating the inflation fight to avoid a recession.
By the end of the month, yields around the world were looking reasonably attractive given the Q3 sell-off, but the attractive real and nominal yields on offer have not lasted. Fed actions and commentary at the November FOMC meeting, weak U.S. business confidence data (alongside very weak European data) and a sharp downturn in employment growth sparked a significant rally. From October 31 to November 3, U.S. Treasury yields fell 38 bps taking them back to levels not seen since mid-September. Similar rallies occurred in most advanced economy bond markets with Emerging Markets (EM) markets lagging behind. This has reduced the attractiveness of government bonds in very quick order as we do not see the U.S. economy moving into recession anytime soon. Inflation is still significantly above target (albeit moving lower) and progress should get harder. Indeed, there are reasons why it might tick up over the next few months. While the Fed may well be done raising rates, it does not mean that they will be cutting rates anytime soon. Therefore, although most central banks are likely finished hiking rates, we are not finished with the era of high rates, the maintenance of which remains critical to win the war against inflation. With markets now pricing in rate cuts in many countries (Eurozone, U.S., Canada) there is a reasonable chance that these cuts either won’t happen or will happen in smaller sizes. It should be noted that the chances of rate cuts in the Eurozone are higher than they are in the U.S., but bond yield differentials and yield curve shapes already reflect this. We are wary of chasing yields lower in this environment. Therefore, we believe a neutral position on interest rate exposure is now warranted while we wait for new data on the extent of the U.S. and global slowdown, particularly on the inflation front.
We do think selective EM bond markets look attractive. Recent U.S. economic data released in November suggest the tightening in financial conditions in Q3 is working to slow the economy. This “bad” news, e.g. the slowing of the U.S. economy, is “good” news for EM. Stable, lower yields, and a weaker dollar are good for EM in general. We prefer Latin American bond markets as central banks in this region have been able to cut rates and are likely to continue doing so if the Fed is truly on hold.
Another beneficiary of lower U.S. Treasury yields and slower growth (not weak growth, that would be bad) is credit markets. Credit spreads had been a casualty of fast rising yields in October, so it was not a surprise when they rallied/tightened as yields fell in the first week of November. If the Fed is truly embarking on a new more benign policy path and with non-U.S. economies struggling in general, credit markets should perform well. However, and it is a major caveat, growth cannot stay strong. This would bring Fed hawkishness back into play, especially if the improvement in inflation slows down. On the other hand, if U.S. growth does materially slow down, the Fed could cut interest rates while still maintaining a tight monetary policy, given cash rates of 5.5%. We think a cautious modestly long position in credit markets both in investment grade and in high yield is warranted. Shorter-maturity high yield bonds do look attractive in this environment. The outlook for inflation will be critical to know if markets need to be worried about credit spreads.
We continue to favor shorter maturity securitized credit, such as Residential Mortgage-Backed Securities (RMBS), Asset Backed Securities (ABS), and selected Commercial Mortgage-Backed Securities (CMBS), the most. That said, the outlook has modestly deteriorated as household balance sheets come under more pressure and excess savings are run down. We are trying to take advantage of higher yields on higher quality issuers to achieve our target returns, rather than venturing down the risk/rating spectrum. Anything that would reduce the chances of further rate hikes and higher borrowing costs is good for securitized credit. Our favorite category of securitized credit remains non-agency residential mortgages, despite challenging home affordability. Surprisingly, U.S. housing looks like it may have bottomed out, with prices rising once again.
The outlook for the U.S. dollar also appears to be changing, though we remain largely neutral. While very strong in Q3 it failed to make new highs in many cases despite supportive fundamentals. As such it looks much more opportune to begin thinking about underweighting the dollar, not versus other advanced economy (AE) currencies but against selective EM ones. Most AE currencies have challenging fundamentals, making them less attractive to buy compared to the U.S. dollar. However, lower, and more stable U.S. yields, combined with still high carry in many EM currencies, make these currencies reasonable alternatives.
Developed Market Rate/Foreign Currency
Developed market rates in October continued from where they left off in September. Data remained surprisingly resilient, yields rose, and curves steepened. Central banks made it increasingly clear they were close to the end of their hiking cycle, if not likely done; however, they also noted that rate cuts were unlikely to happen anytime soon. As a result, front end yields were more mixed, while long end rates were all higher. In the U.S., the 2-year, 10-year, and 30-year yields rose 4 bps, 36 bps, and 39 bps respectively, as the curve steepened sharply. There was no Fed meeting, but data was broadly strong with CPI above expectations and quarterly GDP ending at 4.9% quarter-on-quarter seasonally adjusted annual rate. Yields in the Eurozone were more mixed, with parts of the curve shifting lower as data came in softer than expected. The European Central Bank also opted to stay on hold with the market interpreting the commentary as marginally dovish. Elsewhere, the Bank of China, Bank of Japan, Reserve Bank of Australia, and Reserve Bank of New Zealand kept policy rates the same.1
A key theme in October remained steeper yield curves as the back end came under pressure, while the front end remained largely locked in place. While attributed to many factors, the still-resilient economy, the shift in central bank guidance, and an increase in term premium likely explain most of it. Despite the steep sell-off for long-end yields, it’s unclear if the full extent of selling is done. Many curves are still inverted and term premium, while elevated in the context of the negative levels of the past decade, is still well below the +1-3% levels found before the post-Global Financial Crisis period. At the same time, the higher yields should feed through to tighter financial conditions, putting further pressure on the economy. Given the uncertainty, it is difficult to concretely express an outright view on interest rates; however, we continue to find steepeners attractive at certain parts of the curve as they would keep benefiting from further increases in term premium and/or a more typical bull steepening if the Fed pivots in the face of economic weakness. In terms of foreign exchange, the dollar was largely unchanged, only 0.5%. We remain more neutral on the U.S. dollar, preferring to focus on other attractive opportunities.
Emerging Market Rate/Foreign Currency
Emerging Markets Debt (EMD) produced negative returns across all segments of the asset class for the month. Spreads widened for both sovereign and corporate credit, and most EM currencies weakened. All eyes were on the Fed as the next meeting loomed right after month-end and the U.S. dollar continued to strengthen along with the hawkish sentiment from the market. The onset of war in the Middle East created uncertainty in the region. EM central banks were mixed during the period as some banks such as Indonesia and the Philippines shifted to hikes due to the macro environment while Chile continued to cut rates, though less than expected. A notable EM currency that rallied was the Polish Zloty following the election of a new government, which promises new reform measures and a better relationship with the European Union. Outflows continued for both hard and local currency funds with -$8.0B and -$5.1B, respectively.2
While the Fed is closer to the end of its tightening cycle than to its beginning, the Fed’s terminal rate is uncertain as is how long it will keep its policy rate elevated. More orthodox monetary policy by many EM central banks has allowed them to end tightening cycles and, in an increasing number of cases, begin easing. However, some EM central banks have started to pivot back towards hikes which further highlights the divergence across the asset class. The war in the Middle East is a tragic situation that will continue to be closely monitored. Country and credit level analysis will be pivotal to uncover value in the asset class.
Euro Investment Grade (IG) spreads marginally outperformed U.S. IG spreads this month as October saw credit market spreads widen, with single name volatility increasing where Q3 results missed expectations. Market tone in the month was driven by several factors; firstly, increased geo-political risk as tensions in the Middle East rose. Secondly, strong economic data in the U.S. supported by strong employment data in contrast to Europe where GDP confirmed the weak PMI/IFO signals. Thirdly, Q3 reporting while on aggregate ahead of expectations saw weakness in Energy and Chemicals relative to expectations and some downgrades to growth expectations. Finally, the higher interest rate and commodity/energy and equity volatility led to the market demanding increased risk premium driving credit spreads wider. Notable in the month was the underperformance of high yield relative to investment grade (BBB underperformed A rated) and Financials versus Industrials in USD (unlike Euro where Financials performed in-line supported by low supply with banks funding in the USD market.)3
The U.S. and global high yield markets recorded a weak month in October amid volatile U.S. Treasury yields, U.S. Congressional dysfunction, generally disappointing high yield earnings and war in the Middle East. The technical conditions in high yield softened further in October despite paltry new issuance as demand from retail investors further receded. October marked a clear departure from the consistent outperformance of the lower-rated segment of the high yield market that characterized the preponderance of the first nine months of the year.4
In October, global convertibles fell along with other risk assets for the third month in a row, as the U.S. 10-year rate reached 5% for the first time since 2007. MSCI global equities declined as did the Global Aggregate Credit index. The Refinitiv Global Convertibles Focus Index fared the worst, falling 2.97%. Higher beta convertibles fared the worst, while higher credit quality names such as Utilities held up the most. Issuance was moderate at $3.9bn in October which is consistent with both the time of year and falling stocks.5
Looking forward, our base case remains unchanged, with credit expected to trade around current levels (having widened from the summer tights at the end of July) making carry an attractive return opportunity. We expect supply to rebound in November but disappoint relative to expectations in aggregate for Q4. Although we do see risks of pre-financing 2024 supply needs given the inverted yield curve (meaning holding cash is not expensive for corporates), economic uncertainty into Q1 2024 argues for taking advantage of the market today while it remains open. Finally, there are several factors we are closely watching that could shift the narrative: remaining Q3 corporate earnings, the potential for economic policy support in China and higher energy prices.
The high yield market ended October with a historically attractive yield; however, our outlook and positioning remain somewhat cautious. The need for caution is predicated on prevailing catalysts that include restrictive monetary policy, near term headwinds facing the U.S. consumer, and high yield issuers and valuations that trade inside historical norms. Within convertibles, optimism remains among investors for a strong pick up in supply in coming months due to the theme of rates being higher-for-longer.
Securitized credit spreads remained largely unchanged in October despite an uptick in supply. U.S. ABS spreads were slightly wider for consumer-oriented loans, but business-oriented ABS spreads were unchanged. European securitized market activity slowed in October as new issuance remains historically light. Agency MBS spreads continued to drift wider during the month as both the Fed and U.S. banks continue to reduce their U.S. Agency MBS positions. Current coupon agency MBS spreads widened 1 bp in October to +178 bps above comparable duration U.S. Treasuries. Current coupon MBS spreads are now 35 bps wider year-to-date, in contrast to the U.S. IG corporate Index average spread which is essentially unchanged year-to-date.6
We believe that “higher rates for longer” will continue to erode household balance sheets, causing stress for consumer ABS and further stress for commercial real estate borrowers. Residential mortgage credit opportunities look more attractive to us, given that most borrowers have locked in 30-year fixed rate mortgages at substantially lower mortgage rates, and given that home price appreciation over the past few years has meaningfully increased homeowner equity. We continue to move up in credit quality, adding higher rated opportunities and government-guaranteed agency MBS. We like agency MBS at these wider spread levels, and we continue to add agency RMBS to our portfolios. We have also added duration to our portfolios at these higher rate levels, as we believe the Fed is likely finished its rate hikes, and rates are now likely at or near their peak levels.
Securitized yields remain at historically wide levels, and we believe these wider spreads offer more than sufficient compensation for current market risks. Fundamental credit conditions remain stable despite recession risks; although delinquencies across many asset classes are increasing slowly, overall delinquencies remain low from a historically perspective, and we believe delinquency and default levels will remain non-threatening to the large majority of securities. U.S. non-agency RMBS remains our favorite credit sector despite weakened home affordability. U.S. home prices remain stable, challenged by higher mortgage costs but supported by positive supply-demand dynamics. Stable household balance sheets and employment outlook help support borrower credit and continued conservative loan underwriting also supports the mortgage credit story. We remain more cautious of commercial real estate, especially office, which continues to be negatively impacted in the post-pandemic world. Our European securitized holdings were down slightly in October, and we have meaningfully reduced our European holdings over the past year.