Insights
Dazed and Confused
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Global Fixed Income Bulletin
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November 17, 2022
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Dazed and Confused
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November 17, 2022
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Dazed and Confused
Dazed and Confused |
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Bond markets were a bit more orderly in October than the mayhem experienced in September. That said, markets were still mixed, and investors could be excused for feeling a bit dazed and confused with regards to volatility, dispersion of returns, illiquidity, central bank policies and deciphering how to determine value. Nominal U.S. Treasury and investment grade U.S. dollar bond yields moved substantially higher as strong inflation and labor market data continued, to the disappointment of the Fed and other central banks. However, just to confuse things more, real yields on 10-year U.S. TIPs fell approximately 14 basis points (bps),1 substantially outperforming nominal bonds, despite continued hawkish rhetoric coming from the central banking community. Does this mean real yields are high enough to sufficiently slow economic growth to bring down inflation to acceptable levels?
On the other hand, advanced economy bond markets outside of the U.S. generally performed well, boosted by continued fallout from the UK liability-driven investment (LDI) maelstrom in September, and a pivot by several central banks (Australia and Canada) to downshift their tightening pace. Other central banks like those in Sweden and Norway are also expected to shift to a slower pace of tightening. Other than this news, data or policy pronouncements did not particularly justify this move in and of itself, but German government 10-year yields had risen over 50 bps in September and a correction was understandable.2 Emerging market local yields did not have a great month, with most countries experiencing yet again higher yields as inflation pressures fail to abate.
Despite the gyrations in government bond yields, credit markets performed well. Under constant threat of weaker economic data (this is what central banks are striving for) and higher U.S. and Euro yields, credit markets performed well, particularly high yield. In fact, after widening 68 bps in September during the British LDI meltdown, U.S. High Yield spreads tightened 88 bps in October!3 A truly impressive performance given the sideways performance of equities. This great performance was also helped by record low issuance, continued good news on default rates, good third quarter results so far for S&P companies (tech stock woes notwithstanding), and locked in term financing. Investment grade spreads also held their own: impressive.
The one continuing negative (outside of U.S. rates) has been the performance of the mortgage/securitized credit markets. U.S. agency spreads continued to widen as investor sponsorship remains sparse and the withdrawal of buying by the Fed, other official institutions, and banks weigh on the market despite the paucity of new supply.
Another interesting development in October was the mixed performance of the U.S. dollar. It was not a one-way bet. For the first time in a while, the U.S. dollar fell against almost half of the currencies we follow. In particular, EM currencies led the pack, with the Brazilian real, Hungarian forint, and Polish zloty leading the way.
(+ = appreciation)
(+ = appreciation)
Japanese jawboning and sizeable intervention stabilized the yen below the psychologically important 150 level. This is despite the largest mismatch of monetary policies between the two countries in history. Has the low in JPY been seen? A harbinger of things to come? Maybe. Given recent U.S. data and the Fed’s commitment to keep raising rates until inflation has fallen substantially, it is probably premature to believe the U.S. dollar’s trend has reversed. But before the sun can come out it has to stop raining!
Fixed Income Outlook
Talk of central banks pivoting to dovish stances is premature, we believe. While the central banks of Australia and Canada did reduce their hikes in October to 25 and 50 bps respectively, in neither case did the institutions suggest that they were finished. Indeed, as the Fed communique said after their November 2nd meeting, the Fed should be expected to downshift the size of rate hikes in future meetings. And this is nothing more than logic/ common sense.
With lags in the effects monetary policy has on the economy, the Fed will have to, at some point, reduce the size of their rate hikes and potentially their frequency as they assess the impact of previous rate hikes on the economy. But this is a far cry from discussing stopping rate hikes or discussing rate cuts. Chair Powell seems to have restated using other words. They are not even discussing the possibility of discussing stopping rate hikes. Indeed, central banks, including the Fed, continue to emphasize the need for further rate hikes. What investors need to figure out is how high is high enough. How long is long enough. The pace, the current market obsession, is of secondary importance.
When thinking about monetary policy changes there are three questions investors must ask about a monetary tightening cycle. One, how fast: what is the pace? Two, how high: what is the peak terminal rate? And three, how long: for what time period will rates have to stay in restrictive territory? October and early November central bank actions and communications are beginning to answer question one. But not the others. They remain open-ended and very data dependent, e.g., how strong is the economy; what is driving inflation; how tight is monetary policy, etc.
Market hopes for a resolution of these issues look to be unfulfilled. Normal data volatility can easily give markets false hope that the end is nigh (with respect to rate hikes). These rallies either in rates or credit spreads should be sold. Central banks will not signal the end until there is concrete evidence (not necessarily unequivocal, there rarely is unequivocal evidence) that inflation is trending lower in a sustainable fashion. Of course, the pace of rate hikes will slow before then, but beware false dawns. We have had many of them so far in the post-Covid cycle. U.S. real yields as measured by TIPs yields have risen over 225 bps this year, again an unprecedented amount in less than a year. If you add to this the fact that this has been happening on a global level, you have one of, if not the largest, single year global monetary policy tightening cycles ever seen. We think we are getting close to the endgame in terms of how high yields need to go.
However, it is not all doom and gloom. Central banks have made tremendous progress in getting policy rates into restrictive territory, raising policy rates at a pace not seen for 40 years and helping push real rates, the more important indicator of monetary tightness, up substantially. Global financial conditions are now tighter than they have been for over 20 years, excluding the global financial crisis period in 2008. The U.S. bond market is now discounting a peak Fed funds rate of approximately 5.1% by mid next year. Even the most die-hard hawks on the FOMC have not been talking about rates much higher than this. Income has returned to the fixed income market, making bonds a much more attractive investment than they have been for over 15 years. Unless inflation continues to rise, it might just be possible to begin talking about peak rates, with significant rallies, though still in the distant future, given the stubbornness of inflation and tight labor markets.
While inflation has more momentum in Europe than in the U.S., it may not prove stickier, due to its different underlying causes and much more subdued wage growth. The ECB is likely to continue raising rates another 100 to 150 bps over the next six months, which should provide a headwind to bonds. The UK is different. The economy is weaker. Fiscal policy, unlike in the Eurozone, is expected to tighten significantly. So significantly, in fact, that the Bank of England signaled the market was probably forecasting too many rate hikes rather than too few. UK bonds look a better value than most other markets.
Credit markets look likely to be in a range over the next few months as markets digest incoming data and continually reassess recession probabilities. Spreads are well wide of “normal” or average, but not quite high enough to say a recession is discounted. Indeed, with the recent rally in high yield, that market looks a tad expensive relative to risks in the near term. But with recession risks still likely to be down the road, there is no reason why credit markets cannot do better given their high absolute yields (driven mostly by the sell-off in government bonds).
To get bullish we would like to see a bit more risk premium priced in (e.g., wider spreads) given the still uncertain economic outlook. The U.S. agency mortgage market and other securitized sectors (CMBS, ABS) look inexpensive on most metrics. Indeed, they look attractive enough that we think it will be hard for investment grade credit to rally with U.S. agency MBS doing better. The dollar may be topping. EM bonds continue to gain in attractiveness, but we have yet to see a catalyst to restart a bull market. We remain patient.
| MONTHLY REVIEW | OUTLOOK | |
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| Developed Market Rate/Foreign Currency | After sharp increases in rates during August and September, global developed market rates were mixed in October. Numerous countries saw rates decrease as central banks like the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) appeared to shift to a more dovish approach. Further, the rise in yields following the UK maelstrom reversed as the issues abated, with yields falling significantly over October. On the other hand, in the U.S., yields continued to risefollowing still high inflation data.4 | With continued repricing of rates higher, the market's current pricing for rates is close to fair. However, given the continued high inflation prints and expectations, the risk for rates still seems to be for them to go marginally higher. Central banks are limited in their ability to effectively lower inflation using their current tools and strategy, especially in Europe. Further, volatility across markets is likely going to continue as uncertainty remains. Regarding foreign exchange, the U.S. dollar has benefited from the tighter Fed policy and growing global growth concerns, and we expect this could continue, although likely not as significantly as before. |
| Emerging Market Rate/ Foreign Currency | Hard currency debt performance was positive while local sovereign debt and USD corporate debt were down over the month.5 Emerging markets debt (EMD) performance was mixed in October. Some of the key takeaways of the annual fall meeting of the International Monetary Fund (IMF) included: a bearish tone for global growth, the U.S. dollar is strong but not overvalued, central banks around the globe are likely to remain hawkish, widespread concern surrounding China, and the IMF needs some “wins” which should translate into more flexible policies. | While we expect fundamentals and policies to drive both performance for the asset class as well as variation in performance among countries over the intermediate- to long-term, the macro will likely continue to drive market sentiment near term and outflows remain notable. Valuations across EMD are compelling and seem to be pricing in these risks more aggressively than other asset classes. We expect markets to place an emphasis on differentiation among countries and credits. |
| Corporate Credit | October saw credit markets consolidate following weakness into September quarter end, with Euro and U.S. Investment Grade corporate spreads tightening slightly. Generally, subordinated financials outperformed non-financials, BBBs underperformed higher-rated, and short-dated paper tightened less than longer-dated. Market drivers continue to be focussed on the macro environment.6 The high yield market showed early signs of strength in October but ended the first half of the month essentially flat from a return perspective. The market rallied sharply in the final two weeks amidst a strong technical backdrop and a host of earnings which, on average, exceeded previously lowered expectations. The strong technical conditions were based on near record inflows into the high yield ETFs and virtually no primary issuance. The top performing sectors for the month were brokerage, asset managers & exchanges, finance companies and REITs.7 Global convertibles rebounded from oversold levels in October as volatility rose and a mixed earnings picture contributed to underlying equity performance in sectors such as Energy, Industrials and Healthcare. However, the three highest weighted sectors in the convertibles asset class—communications, technology and consumer discretionary—added less to performance.8 |
Market valuations continue to price a very negative outcome for corporate downgrades and defaults. Corporate fundamentals are resilient and companies have built liquidity in recent quarters 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). We remain cautious on the U.S. high-yield market as we progress through the fourth quarter. Volatility across risk markets remains elevated and, generally speaking, investors' faith in the U.S. Federal Reserve's ability to engineer a soft economic landing remains low. Liquidity and financial conditions are expected to continue tightening moving forward, real economic activity is slowing, the health of corporate fundamentals should begin to decline. |
| Securitized Products | October was another difficult month in the securitized markets. Interest rates rose again, and both agency MBS spreads and securitized credit spreads widened further with supply pressure from distressed selling. Despite the headwinds, securitized markets only marginally underperformed most other sectors in October. Current coupon agency MBS spreads widened, and the Bloomberg MBS Index return was negative. U.S. non-agency RMBS spreads widened further in October, as distressed selling and increasing liquidity concerns weighed on the markets. U.S. ABS spreads were slightly wider in October but were also helped by the lack of new issuance and lighter secondary selling. U.S. CMBS spreads widened in October too as fundamental credit conditions remain challenging in many commercial real estate markets. European securitized markets remain under pressure from heavy selling and weakening credit conditions, and European securitized spreads widened significantly in October.9 | Our fundamental credit outlook remains positive overall, although we are becoming slightly more cautious. Credit spreads for many securitized sectors remain at levels last seen at the depths of the pandemic, but credit conditions appear materially better today. |