Insights
One Small Step for Interest Rates, One Giant Leap for Monetary Policy
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Global Fixed Income Bulletin
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April 27, 2022
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One Small Step for Interest Rates, One Giant Leap for Monetary Policy
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April 27, 2022
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One Small Step for Interest Rates, One Giant Leap for Monetary Policy
One Small Step for Interest Rates, One Giant Leap for Monetary Policy |
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March was another brutal month for financial markets, capping one of the worst quarters since the 1980s. The “safe-haven” status of government bonds, evident as Russia invaded Ukraine, proved ephemeral as the end of February rally quickly reversed and turned into a large March sell-off. Indeed, it did not take long for markets to realize the inflationary/stagflationary implications of the war and resulting sanctions on Russia.
The negative growth implications were ignored as the new shock was going to exacerbate inflationary conditions already on the boil from an overheating global economy beset with supply chain disruptions. Market expectations of central bank rate hikes ratcheted higher, sending global bond yields spiraling upwards: the 2-year U.S. Treasury yield rose 90 basis points (bps) while the 2-year German government bond yield moved into positive territory for the first time since 2014. The U.S. Federal Reserve’s (Fed’s) March meeting was notable in that it resulted in a massive increase in its year-end inflation and rates forecast, justifying the market’s bearishness.
The extent of the shift in monetary policy in 2022 is breathtaking by historical standards. Unlike in February, credit markets somewhat surprisingly outperformed governments with high yield (HY) and emerging market (EM) external debt spreads tightening meaningfully, correcting a significant portion of their February underperformance. HY and EM external lead the way, outperforming with spreads 30-64 bps tighter. Despite the negative implications of the war for the global economy, the U.S. dollar was mixed. European currencies fell modestly, and the Japanese yen was the big loser as the Bank of Japan (BoJ) made it clear it had no intention of following other central banks in tightening policy. EM currencies continued to do well, with Latin America leading the way. Reduced liquidity in financial markets was also noteworthy, exacerbating swings in prices, frequently on a daily basis.
Note: USD-based performance. Source: Bloomberg. Data as of March 31, 2022. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Note: USD-based performance. Source: Bloomberg. Data as of March 31, 2022. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of March 31, 2022.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of March 31, 2022.
Source: Bloomberg, JPMorgan. Data as of March 31, 2022.
Source: Bloomberg, JPMorgan. Data as of March 31, 2022.
Fixed Income Outlook
The Russian invasion of the Ukraine has further intensified existing imbalances in the global economy. The impact will likely be felt through an elongation and intensification of the inflation cycle and falling growth rates (though no recession). Inflation has moved up as have expectations through 2023. Commodity and food prices are likely to go higher still, exacerbating existing inflation problems, making central banks continue their hawkish jawboning and actions. The Fed is notable in this regard. It is very possible it hikes 250 bps this year as it front loads tightening while the economy is strong and shows its commitment to a credible anti-inflation strategy. There is absolutely no doubt in our minds that policy was too easy for too long (especially given the Covid-inspired fiscal policy response) and the Fed needs to “catch up” and get policy to neutral as fast as possible. This may even necessitate multiple 50 bps rate hikes in contiguous months AND sooner than expected balance sheet runoff. So far markets have taken this well, with credit spreads widening relatively modestly and the dollar only marginally stronger. However, if inflation does not fall enough (yet to be defined, but probably no higher than the Fed’s current end of year forecast), expect additional unexpected tightening next year, i.e., a much higher terminal Fed funds rate. This would raise the probability of a recession in 2023 and undermine credit assets.
The Fed’s hawkishness is mirrored across the globe. Indeed, EM central banks have been fighting inflation for over a year. In the case of Eastern Europe, rate hikes have accelerated in recent weeks as has the ECB’s hawkish comments. This global synchronization of policy (outside of China and Japan) alongside stubborn inflation will, we believe, push yields higher globally. Even countries like Australia, where central banks have resisted raising rates, are experiencing very sharp increases in longer-maturity yields. Until inflation has peaked (or a recession is anticipated), which we will not know for several months, we expect yields to remain under upwards pressure.
One reason central banks can be this hawkish is growth is strong. Although inflation is acting as a tax on households and businesses and yields are moving higher, labor markets and corporate profitability are strongly supporting spending. Thus, given the current level and trajectory of yields we do not anticipate a recession either this year or next. The earliest it could happen based on our analysis is 2024. This is a long way off and supports a more 1994 interpretation of this year’s rate hiking cycle as one that will slow things down enough to contain inflation without throwing the U.S. or global economy into a recession. We have to keep in mind that the global economy is decelerating from a very high level. That said, regional issues will occur. The probability of economic underperformance is greatest in Europe and China/ ASEAN. The U.S. will likely remain the growth leader.
As a result, corporate profitability is likely to be varied. The energy, commodities, and defense sectors are likely to benefit; Healthcare and Telecoms will be least affected, and for Utilities it will depend on their exact regulatory and commodity exposure. Both industrial and consumer sectors will be negatively affected, but at least they were experiencing strong demand going into the crisis. However, there is no denying that the impact will be negative, with European corporates more affected. That said spreads are wider than the beginning of the year with notable underperformance of Europe.
Credit fundamentals are mixed. Credit quality is mixed in terms of profitability, earnings have likely peaked, and leverage and margins are plateauing. But balance sheets, liquidity and debt servicing capacity remain exceptionally strong. And, importantly, we still expect very benign defaults and more upgrades than downgrades. We therefore think corporate credit remains sound and would look to add to positions on pull backs. That said, due to central banks’ new-found commitment to contain and reduce inflation over the next 18 months, growth will weaken and it will be important to differentiate those companies who can continue to thrive in such an environment. Active management is likely to be key to performance. We do maintain a preference at the margin for high yield over investment grade but that is very idiosyncratic and industry specific. EM outperformed recently. This is due to valuations, EM underperformed much of the last 12 months; big regional disparities, Latin America benefitting economically at the margin from the war (even if inflation cycle lengthens a bit); and, commodity exporters benefitting, like Brazil and South Africa. We think this trend is likely to continue. Country level analysis will be vital to uncover value as we expect markets to place an emphasis on differentiation amongst countries and credits.
Developed Market Rate/ Foreign Currency
MONTHLY REVIEW
In March, repricing of central bank policy expectations resulted in a global sell-off in developed market rates. The movement included historic increases in front-end rates, a positive German 2-year yield for the first time since 2014, and 2-10s and 5-30s yield curves inversions in the U.S. Treasury market. Facing higher energy prices given the war in Ukraine, inflation figures remained elevated and surprised to the upside in many areas. Central bank policy was once again the dominating theme. Central bankers indicated to markets that despite everything going on in the world, from war to a resurgence in Covid cases, they are serious about tackling the inflationary pressure that still looms large and are willing to take the drastic measures necessary.1
OUTLOOK
We still believe that inflation will continue to surprise to the upside. The war lingers on threatening energy prices and supply chain disruptions remain, and potentially are worsening, with lockdowns in China given Covid resurgence. Central banks are relatively limited on actions to combat inflation directly at the current moment. We expect central banks to continue normalizing policy; however, they may be forced to take a more cautious approach than they are now projecting if the war in Ukraine intensifies or if the market starts to price in expectations for a recession. We still have limited conviction on the direction of currencies.
Emerging Market Rate/ Foreign Currency
MONTHLY REVIEW
Emerging markets debt (EMD) indices sold off notably across the board during the month as markets sought to digest the Russian invasion of Ukraine, further stress in the China property market, and the pricing in of an increasingly hawkish U.S. Federal Reserve (Fed). Inflationary pressures remain elevated in most EM countries with the commodity-price channel effects of the Russia/Ukraine conflict. EM central banks have continued reacting with orthodox monetary policy. U.S. dollar-denominated corporate debt,2 local sovereign debt, 3 and U.S. dollar- denominated sovereign debt also seeing negative returns.4
OUTLOOK
We are optimistic on EMD as valuations appear to be well-compensating investors for the risk. The Russia/Ukraine war will continue to drive headlines and may continue for quite some time. Fundamentals are mixed and while Fed tightening is a concern, markets appear to be pricing that in somewhat aggressively. The growth and inflation dynamic remains critical. Country level analysis will be vital to uncover value as we expect markets to place an emphasis on differentiation amongst countries and credits.
Corporate Credit
MONTHLY REVIEW
Credit spreads tightened in March with general market volatility calming after a rocky February. Over the month, markets reduced expectations that the impact would be systemic for markets outside the impacted region. Sector/corporate news in the month was limited to idiosyncratic news and speculation over the impact of increased cost inflation in the supply chain.5
The high yield market remained weak in the first half of March but strengthened in the final two weeks. Over the month, yields rose and spreads tightened and there was a brief period of inflows into the asset class, the latter of which has been exceedingly rare in the current environment.6
Global convertibles balanced between negative sentiment in the bond market from rising rates and improved sentiment in the equity on hopes that the Russia-Ukraine conflict may de-escalate. New issuance over the quarter was the second weakest first quarter on record, below only the first quarter of 2009, largely due to a weakening equity market.7
OUTLOOK
Looking forward we see spreads likely to be rangebound. Markets are supported by technical demand, valuations look attractive relative to recent levels and expectations that the Russia/ Ukraine war is not systemic outside the region, leading to global default rates staying low. This is balanced by the expectation of supply and tighter financial conditions that are driving the yield curve flatter, potentially signalling an economic slowdown.
Floating-Rate Loans
The floating-rate corporate loan market experienced a smoother path than most of its index counterparts across the fixed income landscape. Technical conditions in the loan market were relatively balanced for the month. Fundamentals continued to showcase the health of corporate credit markets through the month.8
OUTLOOK
We maintain our expectations for a strong year in loans as rising interest rates historically have been bullish for the asset class. Additionally, we remain in an appealing credit environment. As with all crises, it will take time for uncertainty to abate. In the meantime, this asset class has showcased its durability yet again.
Securitized Products
MONTHLY REVIEW
Agency MBS underperformed again in March. Spreads are now materially wider than pre-pandemic levels as the market is anticipating the end of quantitative easing and likely the beginning of quantitative tightening, but agency MBS spreads could widen further as the Fed continues to reduce its purchases. U.S. Non-agency RMBS spreads were significantly wider across all residential sectors in March as nearly all risk assets cheapened given concerns about inflation, central bank policies and geo-political events. U.S. ABS spreads were also wider in March, but fundamental performance remains strong.9
OUTLOOK
We believe the securitized market still offers a unique combination of low duration, attractive yield, and solid credit fundamentals. We remain constructive on securitized credit and cautious on agency MBS and interest rate risk.
Risk Considerations
Diversification neither assures a profit nor guarantees against loss in a declining market.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.