Global Fixed Income Bulletin
December 31, 2022
2022: Good-Bye, Farewell, Amen!
Global Fixed Income Bulletin
December 31, 2022
2022: Good-Bye, Farewell, Amen!
December 31, 2022
2022 ended with a bang; unfortunately not a good one! December proved to be a fitting end to a terrible year for bonds and financial assets in general, with yields up significantly once again. Optimism based on declining inflation, weaker growth, and less hawkish central banks proved to be illusory. The Fed, European Central Bank and Bank of England all raised rates 50 basis points (bps). The ECB emphasized they were far from done, with their multi-year inflation forecast still above target. The Fed appeared to backtrack a bit on their November comments about wanting to wait and see how previous tightening was impacting the economy before committing to additional rate hikes. The change of tone was noticeable. Not surprisingly, European bonds were hit particularly hard, with French 10-year yields up over 70 bps on the month and Germany not far behind. U.S. Treasuries did reasonably well, with 10-year yields up only 27 bps. Credit markets bucked the trend a bit with U.S. investment grade and European credit markets marginally tighter on the month. U.S. high yield was the outlier, with spreads over 20 bps wider on main indexes. Securitized markets also did well in spread terms, as they continued to play catch up to the corporate credit markets. Equities, after staging an impressive rally over late summer and early fall, also did terribly, with the S&P 500 down almost 6% on the month.
Why did yields rise so significantly? Several factors were at work. First was continued hawkishness from central banks. It might have been wishful thinking more than fact-based analysis, but markets expected some softening in actions/rhetoric from the Fed and ECB. No such luck. Second was the surprising action by the Bank of Japan (BoJ) to adjust their yield curve control (YCC) policy. They increased the top end of the range on 10-year government bonds (JGBs) to 50 bps from 25 bps. While not such a large move in absolute terms, it was earth shattering given prevailing expectations. The move hinted at more adjustments to come in 2023, both in terms of yield curve targets as well as conventional monetary policy. This change improves the attractiveness of Japanese government bonds to domestic investors, who may decide to allocate less to offshore markets. This worry, in addition to the worry that another major central bank was about to embark on a tightening path of an unknown amount, boosted anxiety and volatility.
If increased nervousness about central banks was not enough, other forces were also at work. China decided to abruptly drop their zero-Covid strategy and move immediately to a world with no Covid restrictions at all. While this was expected to happen in 2023, it was expected to be gradual. Although this may have some short-term negative impact on growth, it will also accelerate the reopening of the economy, boosting growth, domestically and abroad, and maybe slow down global disinflationary forces. Chinese equities took the policy change well, suggesting optimism about getting the economy back on track.
The actions in China and Japan had a particularly negative impact on Australian dollar bonds. The Australian central bank (RBA) had become one of the most dovish G10 central banks, supporting their bond market. But, the China reopening and revised BoJ policy sent shivers through the Australian bond market, causing Australian 10-year yields to rise over 50 bps, reversing their previously strong performance versus U.S. Treasuries.
Another notable development in December was the continued weakness in the U.S. dollar. A combination of valuation, increased hawkishness of other central banks (ECB, BoJ, in particular), and continued decent growth outside the U.S. boosted non-U.S. economies, hurting their bonds, but helping their currencies. We believe that a weaker dollar is an important indicator that the worst is past for the global economy, particularly for emerging markets.
There is some good news. Yields are higher than they were at the end of November (let alone the beginning of 2022), boosting 2023 expected returns, the U.S. dollar is no longer going up, and credit spreads are meaningfully wider than they were in early 2022. And, in a truly historic way, the stock of negative yielding bonds has gone to zero for the first time since 2014! A notable achievement, putting income back into fixed income, which can help provide a greater cushion for unexpected negative surprises. It only took a record setting sell-off and the worst returns in over 100 years to do it. May negative yields rest in peace.
Fixed Income Outlook
From a bond market perspective, 2023 starts in a stronger, more secure place. Yields are materially higher and spreads wider, suggesting much better 2023 performance and a much more comfortable cushion against unexpected shocks. Even if government bond yields go up this year, it is unlikely they will go up enough to offset their carry/income. It is very rare for bonds to have negative returns two years in a row. But 2022 was weird. Extrapolating anything from last year may be challenging.
The global monetary policy tightening cycle will likely end by mid-year, significantly reducing policy uncertainty. The likely dispersion of policy rates relative to expectations will be much lower in 2023, e.g., will the Fed funds rate be 4.75% or 5.25%.
Uncertainties do remain, but they have more to do with recession rather than inflation/monetary policy outcomes. The question “how hard a landing will economies have in 2023?” will determine the direction and magnitude of yield and spread movements. Last year reminded everyone that inflation shocks are bad for almost all financial assets. Inflation at decades highs required interest rates at decade highs. High interest rates increase real yields, which undermine valuations across credit and equities. That said, we have never had a year with double digit negative returns in both bonds and equities. 2023 has to be a lot better, doesn’t it?
We think so. Yields are much higher, closer to their pre-pandemic average. We expect 2023 will be a much stronger year for fixed income and we think it will generate decent positive returns. There is no doubt in our mind that fixed income should be back in fashion given yield levels and ongoing uncertainty about equities, and likely much less dispersion in possible outcomes.
The first bit of uncertainty is how much more central banks will hike rates. The good news is that whatever they do, it will be a lot less than in 2022 and a lot of what they will do is already expected. Indeed, several emerging market central banks have ended their hiking cycles believing they have done enough to bring down inflation. So monetary policy shocks are likely to be a lot less. But, markets remain generally more dovish than central banks, creating the possibility of unpleasant surprises.
For example, while the peak Fed funds rate anticipated by the market is only 25 bps lower than what the Fed has forecasted, there is a major disagreement. The Fed believes this number, approximately 5%, is likely the floor, while the market not only believes it is the peak but will fall significantly over the course of late 2023 into 2024. If the Fed is right, meaning the U.S. economy is stronger and/or inflation will remain sticky, the U.S. bond market will need to reprice. This would likely take U.S. Treasury 10-year yields back over 4%. The good news is that the likely poor outcome is only about a 50-bps increase. Much less than 2022 and less detrimental to returns given higher starting yields. Similar analysis applies to other developed country bond markets.
It is also possible that central banks have done enough to slow aggregate demand sufficiently to entrench the disinflationary trend. Central banks have made tremendous progress in getting policy rates into restrictive territory. They raised policy rates at a pace not seen for 40 years, helping push real rates, the more important indicator of monetary tightness, up substantially.
The major disagreement between the market and the Fed remains how long rates will have to stay at 5%. It is in the Fed’s interest to talk tough to keep financial conditions restrictive during the disinflationary process. But the market believes, and history supports, that the Fed will reverse course once inflation is back on track towards 2% and/or monthly job growth turns negative. This reflexivity will contain any rises in long-term yields. The biggest risk to this otherwise sanguine outlook is continued stickiness in inflation and wages.
The fixed income sector we are most upbeat on is the securitized market, despite high interest rates and the risk of a recession in the U.S. and Europe. The securitized market consists primarily of residential and commercial mortgage-backed securities and asset-backed securities. Yields on most of these bonds are double last year’s, with spreads materially wider than in corporate credit markets (except for CCC-rated corporate bonds). We believe credit concerns are overdone and yields (either through spread compression or lower government yields) will end 2023 lower. Our favorite category of securitized credit remains non-agency residential mortgages, despite expectations that U.S. home prices will likely fall in 2023. In addition, we prefer U.S. opportunities over European opportunities given valuations and economic risks, including policy risks.
Corporate credit markets had their worst performance on record in 2022. At current valuation levels, investment grade bonds appear neither rich nor cheap. But yield levels look attractive, which should attract investor interest. While we do not think investment grade credit spreads will trade meaningfully lower in 2023, the yield on offer provides good risk mitigation against rate shocks or even a mild recession, given the strong starting point of corporate fundamentals. We are buyers on weakness.
A similar analysis supports high yield credit markets, albeit with more risk stemming from a possible 2023 recession. That said, we do not see a major recession and expect slow/below trend growth with gradually rising unemployment. Default rates are likely to rise but not spike, as expected in a traditional recession. This potential recession, if it occurs, will likely look different as nominal GDP and wage growth remains strong. With high yield indexes yielding around 9%, there is ample room for spreads to widen and still generate mid-single digit returns, if not higher. Moreover, it would also be highly unusual to have two years of negative high yield returns in a row.
The U.S. dollar looks like it has peaked. Further weakness may take time, particularly if the Fed follows through on NOT cutting rates in 2023. Emerging Market (EM) bonds continue to gain in attractiveness, and we expect local markets and FX to outperform. Real yield differentials to U.S. Treasuries remain at historically wide levels. China’s reopening should be quite positive for EM in general and helpful for the global economy. On the negative side, a stronger Chinese economy may make it harder for developed market central banks to bring down inflation. EM external remains the least favored sector in the EM fixed income complex.
Developed Market Rate/Foreign Currency
Yields ended the year higher following a broad sell-off during December, as economic data remained relatively strong, central banks demonstrated that they are still committed to hiking as much as necessary, and Japan modified its yield curve control policy. The U.S. 10-year closed at 3.88%, around 225 bps higher than the level at which it started the year. During the month, the Fed slowed its pace of hiking as expected, raising the policy rate by 50 bps. Similarly, the BoC, SNB, BoE, and ECB all also opted for 50 bps hikes. Notably, the BoJ surprised markets by adjusting its yield curve control policy, widening the allowable deviation from the 0% target for the 10-year yield to 50 bps from 25 bps previously. As a result, Japanese government bonds, unrestricted by the limit, immediately sold off to a level more consistent with fundamental pricing, while the Japanese Yen strengthened.1
Outlook While the Fed has officially stepped down its pace of hikes, the future path of rates is more important. How high and for how long central banks will go will largely depend on growth and inflation conditions. In our view, the rates market is priced close to fair; however, central banks have been clear in their determination to keep rates high, and while inflation will continue to come down from the earlier peak, inflation and labor market data prints are still indicating that the economy is overheated. If that continues, inflation may remain higher than central bankers find comfortable. As a result, the risk for rates still seems to be for them to go marginally higher. The U.S. dollar has benefited from tighter Fed policy and growing global growth concerns. With that said, the dollar strength trend has stopped and started reversing over the past couple months. We think that dollar weakness could continue for now.
Emerging Market Rate/Foreign Currency
Monthly Review Emerging markets debt (EMD) continued to rebound in December supported by the less hawkish Fed and weakening U.S. dollar. China announced a reversal of its zero-Covid policy at the beginning of the month, which markets cheered. Technicals continued to recover as hard currency flows turned positive and local flows plateaued.2
Outlook Following the strong rally to close out the year, we believe there is additional value to be gained from EMD in 2023. We see attractive opportunities particularly in local rates, as real yield differentials between emerging and developed markets remain near historical highs. Fundamentals continue to improve, technicals are turning positive, and valuations remain compelling. China’s move away from a zero-Covid policy and its announcement of substantial support for the property sector will support growth and likely flow through to the broader EM market.
Monthly Review Euro IG spreads outperformed U.S. IG spreads in the rally this month, as the marginal news was deemed positive; mainly driven by signals of the market understanding better central bank comments, and the potential for China to re-open. The dominant driver of the rally was swap spread tightening, with the 10-year spread 9 bps tighter at +64 bps. The iTraxx Europe, in contrast, underperformed as it drifted 3 bps wider in the month, closing at +91 bps, leading to underperformance of derivatives versus cash.3
The strong tone in U.S. and global high yield markets extended into the first two weeks of December. However, the tone shifted after the Fed’s December meeting. In addition, the supply/demand balance weakened in December due to renewed outflows from retail funds in the bottom half of the month. The lowest quality segment of the market continued to generally underperform in December. The top performing sectors for the month were banking, basic industry and insurance.4
Global convertibles fell in December, amid rising rates and the latest Covid spread, as the Refinitiv Global Convertibles Focus Index fell 1.71%. Convertibles performed in between global stocks and global bonds to complete the worst annual convertible returns since 2008.
Outlook Looking forward, our base case view is that we are compensated to own credit as we view corporate fundamentals to be resilient and the macro backdrop to likely improve as monetary policy pivots and China re-opens. We view companies as having built liquidity and implemented cost efficiencies under the Covid-era. We expect margins to be pressured and top line revenue to be challenging (as evidenced by Q3 numbers), but, given the starting point we believe corporates will be able to manage a slowdown without significant downgrades or defaults (base case low default and mild recession).
In the high yield market, spread widening seems to be the most likely path forward due to several factors, including a shift higher in the Fed Funds terminal rate, a tightening in global liquidity and financial conditions and slowing global economic growth.
We believe the positives for convertibles heading into 2023 are a market poised to rebound off its bond floor, and strong impetus to bring new balanced paper as rates continue to rise.
Monthly Review Agency MBS spreads were unchanged in December, and securitized credit spreads tightened during the month. Securitized credit spreads lagged much of the corporate credit spread tightening in the fourth quarter and continue to look attractive on a relative value basis. New issue securitized supply remains very low as loan origination in both residential loans and commercial loans has declined substantially. Securitized fundamental credit remains stable – delinquencies are rising slowly, but remain low from a historical basis, and do not appear to be threatening to the thick levels of structural credit protection for most securitized assets. U.S. home prices have fallen ~5% from the peak in June.5
Outlook Our fundamental credit outlook remains positive overall. We expect home prices to fall another 5-10% in 2023. U.S. residential credit remains our favorite sector, despite our expectations of home price declines, with a strong preference for seasoned loans (originated in 2020 or earlier) due to the sizable home price appreciation over the past few years. We remain more cautious of commercial real estate, which continues to be negatively impacted in the post-pandemic world and could also be impacted by a recession. We are biased to own U.S. over Europe as risk-adjusted opportunities look more compelling in the U.S.. U.S. and European securitized spreads are comparable across similar asset classes, but risks of a more severe recession appear greater in Europe.