Global Fixed Income Bulletin
September 30, 2023
September 30, 2023
September Slump! A "Real" Story
September 30, 2023
September was a difficult month for global fixed income with rates rising, spreads widening and the dollar strengthening. The global growth picture took a turn for the worse, and the probability of a recession next year grew as financial conditions tightened and real yields rose despite improvements in inflation. That said, the inflation picture in both the developed markets (DM) and emerging markets (EM) has proven stickier than previously anticipated, forcing central banks to readjust their expectation for future easing. In the U.S., the FOMC decided to keep the Fed funds rate unchanged but removed multiple rate cuts from their expectations for 2024 and 2025, causing the yields at the long end of the Treasury curve to rise substantially, steepening the yield curve along the way. For example, the U.S. Treasury (UST) 2-Year/10-Year spread in the U.S. steepened by roughly 30 basis points (bps) over the month. Rates in other developed market economies followed the same path as the “higher-for-longer” rhetoric prevailed with yields rising and curves steepening. EM rates rose broadly, more than any other month this year, as DM yields rose, the price of oil continued to climb, China’s growth story continued to deteriorate, and the USD continued to strengthen. All four factors are undermining the bull story for EM debt. The USD strengthened 2.5% versus a basket of other currencies over the month as the growth picture relative to the rest of the world improved further and the U.S. consumer remained strong. Regarding credit, the U.S. largely underperformed the Euro-area with financials being the main culprit for the underperformance, with high yield also generating negative returns. Securitized spreads were broadly wider over the month as well.
Fixed Income Outlook
After modest underperformance in August, bond yields across the world rose dramatically in September. Is it real? Without a doubt! It actually happened and is likely to hang around for a while, and yes -- it was driven by a startling increase in real yields. That’s good for longer-term investors, but maybe a problem in the short run. In fact, U.S. Treasury 30-year yields were up close to 50 bps with approximately 32-bp of that due to a rise in real yields as measured by the yield on the U.S. Treasury 30-year TIPs security. Moreover, several EM countries’ yields were up over 60 bps. Interestingly, sovereign bonds bore the brunt of the sell-off as investment grade spreads barely moved with only U.S. high yield and U.S. Commercial Mortgage Backed Securities meaningfully underperforming government bonds. It also looked peculiar, at least at first, that government bond yields rose so much as the S&P 500 equity index fell almost 5%.
While there was no specific event in September for which one can blame the sell-off, accumulating data releases over the summer weighed on markets. In a quite unusual move, yield curves bear steepened; that is long-end yields rose more than shorter-maturity ones and rose despite no negative inflation surprises; in other words, real yields and term premiums rose. In addition, inflation was well behaved, so inflation worries were not the cause of the vicious sell off. We believe a reasonable explanation for market volatility goes as follows: U.S. economic growth has been accelerating all year, which surprised analysts; the U.S. budget situation looks bad, sending more and more U.S. Treasuries into the market at the same time that the Fed is shrinking its balance sheet; the Fed has been adamant that the inflation game has not been won so markets should expect the Fed to keep rates unchanged (at the September FOMC meeting, the Fed eliminated several rate cuts from their 2024 forecasts). In other words, rates would be kept higher for longer; market positioning seems to be skewed to being long interest-rate risk, making bonds vulnerable to disappointing news; and lastly, the coup de grace is that the U.S. yield curve has been highly inverted, making longer maturity bonds less attractive than shorter ones. Cash has been king! Add it all up and you have a good cumulative narrative as why longer-term yields rose. Importantly, while the velocity of the selloff looks extreme, the end point, a U.S. Treasury 10-year yield ending September at 4.57%, does not.
Why does this matter? The attractiveness of bonds depends on why yields are high. If it is because real yields are high, that is good. High real yields usually lead to good bond market performance. That certainly is partially what happened in September, but term premium seems to have risen as well and that is a measure of riskiness. So, if the primary reason yields rose was increased riskiness and they still offer lower yields than cash, rising yields are not a reason to get bullish. We remain concerned that the rise in real yields/term premiums is likely to continue as long as two things transpire: one, the yield curve remains inverted, making longer maturity bonds less attractive; and two, the U.S. economy cools. An accelerating economy is not conducive to lower yields, in fact, it is usually associated with higher yields.
Economic growth outside of the U.S. has been much less impressive with Europe and China flirting with recessionary conditions. However, that has not stopped European and EM bond yields from rising (China’s yields have essentially not moved at all). If growth outside the U.S. had not been so weak, U.S. yields would probably have moved even higher. While non-U.S. bond markets have generally outperformed U.S. Treasuries, absolute yields have been driven higher by the surprising strength of the U.S. economy and the doggedness of the Fed in combating inflation with high rates. 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. Although valuations have improved considerably, we are not yet ready to declare they have peaked and remain cautious in interest rate positioning in portfolios. While growth fundamentals are worse outside the U.S. (except ironically perhaps for Japan) we do not think non-U.S. government developed markets are much more attractive than U.S. Treasuries. There is a reasonable probability that growth dynamics are in the process of bottoming in Europe and Asia and will turn up next year at the very time the surge in real yields slows the U.S. economy. As such we are fairly neutral on DM government markets on a relative basis.
We do think selective EM bond markets look attractive, but that attractiveness has been undermined by the strong U.S. economy, hawkish Fed, and rising yields. Selectivity remains the name of the game and patience is necessary to realize value in many of these markets while the U.S. economy and U.S. dollar outperform.
One potential casualty of higher yields, wider credit spreads, and softer equity prices is the economy, particularly in the U.S. Until September, the probability of a “soft landing” grew as falling inflation, stable unemployment, and reasonable growth looked increasingly feasible. However, the rise in yields on the back of increased confidence the Fed would not be lowering rates as much and as soon as expected, resulting in a meaningful rise in real interest rates, increases the chances a harder landing will occur and possibly a recession. While it is way too early to assign this as the most likely scenario given what we currently know about economic activity, credit and equity markets have had to price in this higher probability, resulting in poor performance. We are also concerned about the ability of higher risk assets to outperform in an era of inverted yield curves and high cash rates. The solid fundamentals we have witnessed year to date (low default rates, more credit rating upgrades than downgrades, etc.) could easily begin to deteriorate over the months ahead. We therefore remain cautious about maintaining anything above a modestly long position in lower-quality fixed income. Selectivity will remain of paramount importance. Avoiding defaults and blow-ups will eventually be key as higher rates and refinancing risks feed into corporate performance and outlooks. The high yields on offer will blunt underperformance if fundamentals do deteriorate, in our view. As always--caveat emptor!
We continue to favor shorter maturity securitized credit (Residential Mortgage Backed Securities (RMBS), Asset Backed Securities (ABS), selected CMBS) as offering the best opportunities in fixed income. 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. Our favorite category of securitized credit remains non-agency residential mortgages, despite challenging home affordability. Somewhat surprisingly, U.S. housing looks like it may have bottomed out, with prices rising once again.
Recent good news on the U.S. economy and the surge in yields has helped the dollar strengthen further. While the U.S. dollar looks vulnerable in the medium term, other DM currencies do not offer compelling advantages at the moment. Negative growth dynamics in Europe and China are undermining the attractiveness of these and other EM currencies. The most undervalued currency continues to be the Japanese yen but given the slow-moving nature of Japanese monetary policy and still exceptionally high hedging costs, it will be difficult for the yen to rally until Japanese rates move higher or U.S. rates fall. We have moved to a neutral stance on the dollar versus both developed and EM currencies as the differentiated economic performances in the U.S. and China undermine the ability of EM currencies to strengthen. Likewise, we have downgraded our views and exposures in EM local rates. Longer term, many EM bond markets look attractive, but for now the pincer of stronger U.S. growth, weaker Chinese growth, and a stronger U.S. dollar undermines their case.
Developed Market Rate/Foreign Currency
Developed market rates moved sharply higher in September as data depicted economic resilience and term premium appears to have increased. Front-end yields did rise, but less than long-end yields, as central bank policy expectations remain relatively consistent as the hiking cycle approaches an end. As a result, continuing from August, yield curves were steeper (U.S. 2/10s rose 28bps), but somewhat unusually the curve bear steepened as the focus was on long-end selling. In the U.S., the 10-year yield rose 46 bps with the Fed reiterating a hawkish, higher-for-longer stance. The Fed’s median dots for 2024 policy rates were lifted 50 bps to 5.1% from 4.6%, implying an indicated cut of only 50 bps vs 100bps prior. Yields in the Eurozone were also higher with the European Central Bank surprising with a 25bps hike vs expectation for a pause. The Bank of England held, but with a hawkish tone, surprising markets expecting a hike. In contrast, Saudi National Bank held rates vs expectations of a hike. Elsewhere, the Reserve Bank of Australia, Bank of Canada, Riksbank, Norges Bank, and Bank of Japan kept policy rates the same, largely as expected.1
The key theme that drove markets in September was the steep selloff on the back end. While attributed to many things, the still resilient economy and an increase in term premium likely explain most of it. Looking at term premium, the NY Fed’s ACM Term Premium model for 10-year USTs increased from -51 bps at the end of August to +16 bps by the end of September. Going forward, despite the steep sell-off, it’s unclear if the full extent of selling is done. The curve is 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-GFC 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 again strengthened during September with the U.S. economy showing more resilience vs weaker global growth. We are fairly neutral on the U.S. dollar now, preferring to focus on other attractive opportunities.
Emerging Market Rate/Foreign Currency
Emerging Markets Debt (EMD) continued to sell off across all segments of the asset class for the month. A strong U.S. dollar, rising U.S. yields, and a more hawkish sentiment from the U.S. fed weighed on the asset class. Inflation continues to decrease in emerging markets and a number of EM central banks cut rates including Chile, Uruguay, and Poland. The Turkish central bank massively hiked rates in an effort to implement new orthodox policy. Sovereign spreads widened while corporate spreads tightened month-over month. Commodities prices increased and oil rallied as OPEC cut production. Outflows continued for both hard currency and local currency funds bringing YTD flows to $-14.2B and $-3.2B, respectively.2
Looking forward, pockets of value and attractive investments remain for EMD, but country and credit level analysis will be crucial to uncover that value. This is especially important as the U.S. Fed remains “higher-for-longer,” which negatively impacts the macro backdrop for EMD.
Euro Investment Grade (IG) spreads outperformed U.S. IG spreads this month as September saw credit markets marginally tighter, driven by three main factors. First, central banks’ commentary signalled rates will be higher for longer. Second, fundamental economic data did not change the narrative of a strong labor market and inflation trending lower but still above target and potentially sticky, and forward-looking indicators are still signalling weakness (PMI’s/IFO). Finally, there was stronger demand for high quality fixed income, as yields moved higher supporting the positive technical narrative for IG Credit.3
The U.S. and global high yield markets recorded a weak month in September. The quarter ended with a softer tone as global rates moved sharply higher on the back of hawkish rhetoric from global central banks. The technical conditions in high yield softened modestly in September amid a post-Labor Day surge in primary issuance and modest outflows. The lower quality segments of the market generally outperformed for the one-month period, even after underperforming in the latter half of September.4
In September, global convertibles fell along with other risk assets for the second month in a row. MSCI global equities declined 4.27% in the month and Bloomberg Global Aggregate Credit fell 2.72% while the Refinitiv Global Convertibles Focus Index was slightly better, falling only 2.04%. Convertibles held up best in Europe, while declining more in the U.S. and Asia. No sectors were spared as all declined in September, but supply remained strong, with $9.2bn in new paper coming in September, the second-best month of the year.5
Looking forward, our base case remains unchanged with credit expected to range 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 slow over Q4 reflecting the front loading of issuance given concerns for the economy in H2 (although we do see risks of pre-financing 2024 supply needs given the inverted yield curve means holding cash is not expensive for corporates). Finally, there are several factors we are closely watching that could shift the narrative: Q3 reporting, the potential for economic policy support in China, and higher energy prices.
The high yield market ended the third quarter 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. We remain constructive on the asset class as the market is priced around fair value, below par and can be bought at low values of volatility.
Securitized credit spreads were mixed in September, with CMBS spreads wider than other securitized credit sectors. U.S. ABS spreads were largely unchanged over the month for consumers, but business-oriented ABS spreads continued to tighten. European securitized spreads tightened over the month and market activity increased, primarily in RMBS and ABS, and supply continues to be met with healthy demand. 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 8 bps to +177 bps above comparable duration U.S. Treasuries. Current coupon MBS spreads are now 34 bps wider year-to-date, in contrast to the U.S. IG corporate Index average spread which is 10 bps tighter 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 rates, and given that home price appreciation over the past few years has meaningfully increased homeowner equity. We like agency MBS at these wider spread levels, and we are moving up in credit quality by adding higher rated opportunities and government-guaranteed agency MBS to our portfolios.
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 historical perspective, and we believe delinquency and default levels will remain non-threatening to the large majority of securities. Our favorite sector remains residential mortgage credit, and home prices have proved to be extremely resilient to declines despite the increase in mortgage rates, only having fallen 1% since the peak in June of 2023. Within the U.S. residential sector, we have a strong preference for seasoned loans (originated in 2020 or earlier) due to the sizable home price appreciation over the past few years and potential future home price declines. 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 September, and we have meaningfully reduced our European holdings over the past year.