Fixed Income Outlook: 4 Key Questions

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By Komson Silapachai, Research & Portfolio Strategy

The first quarter of 2022 was one of the worst quarters for the US bond market since the inception of the Aggregate Bond Index in 1976. The worst quarters were the first and third quarters of 1980, during the rate hike cycle when Paul Volcker raised the federal funds rate to 20% . This move sent the US economy into a slowdown to combat the “stagflation” dynamic that took hold in the late 1970s.

Quarterly returns of the Bloomberg Aggregate Index
Source: Sage, Bloomberg

Investors face a similar environment in 2022. An increasingly restrictive FOMC has resulted in rising risk premiums for all assets. Yields have risen sharply and credit spreads and risky assets have weakened. Aggregate demand, already forecast to slow, is now facing additional pressure from lower consumer spending. The Fed remains heavily focused on inflation due to persistently higher inflation data, ongoing labor shortages and a commodity shock triggered by the Russia-Ukraine war. As a result, the yield curve priced in much more aggressive Fed policy over the quarter.

Fixed income assets were negatively impacted as interest rates were re-rated to reflect an increasingly hawkish Fed. As yields moved up the curve, the 2-year and 5-year points were the hardest hit. Markets used to price in a larger number of rate hikes (8 hikes of 25 basis points each in 2022 alone), but longer-dated yields rose much less – flattening the yield curve into an inversion, which typically heralds an economic slowdown. In addition, the Fed is expected to trim its balance sheet, leading to additional selling pressure in Treasuries and MBS, which widened dramatically.

Corporate bonds were notably resilient on a spread basis, with investment grade and high yield corporate spreads widening just 24 basis points and 42 basis points, respectively. Credit fundamentals were undoubtedly strong during the stimulus-driven post-Covid recovery; However, as the Fed continues to tighten conditions ahead of an economic slowdown, credit spreads could widen slightly. We believe the risk/reward trade-off for companies is unattractive relative to other sectors that have already re-rated, such as MBS.

Fixed Income Yields: Year End vs. 1Q22
Source: Sage, Bloomberg

Next, we take stock of the current market environment using the Sage Macro Framework (Growth, Politics, Valuations, Sentiment), which answers the question: What can investors expect in the coming quarter?

Growth: what is the underlying growth/inflation picture?

Inflation will remain the main theme for investors in the coming quarter, particularly rising private sector input costs. The tailwinds from consumer spending during the early expansion phase have largely dried up as savings rates are close to long-term averages and households now have to contend with rising fuel and possibly commodity prices. On the corporate front, rising input costs for labor and raw materials could squeeze margins lower. The two key indicators that will clarify the inflation picture and its impact on aggregate demand in the coming months are job vacancies (represented by JOLTS) and gasoline prices. While we expect labor market tightness to improve as consumers look to unincentivized income replacements, energy and commodity prices could remain elevated on supply chain issues amid the Russia-Ukraine war.

US Jobs (thousands) US Gasoline Prices (cents/gallon)
Source: Sage, Bloomberg

Politics: How are politicians reacting?

As expected, the FOMC executed its first rate hike in March and delivered an aggressive message in terms of both written/verbal communication and the FOMC “dot plot”. Midpoint points show seven rate hikes in 2022 and an above-neutral final rate of 2.75% when the FOMC stops raising rates (compared to its estimate of the neutral rate of 2.375%). A week after the March FOMC meeting, Chairman Powell hinted at a potential 50 basis point hike in the near term, revealing the Fed’s intent to hike rates further than signaled during the March FOMC announcement. The Fed focuses solely on inflation and is very insensitive to a slowdown in US economic growth. While there were signs of a slowdown in US economic growth, as well as potential growth shocks from the Russia-Ukraine war, Powell repeatedly pointed to the strength of the US economy and its ability to withstand much tighter financial conditions. For us, that was a hawkish signal – the bar for a slowdown will be set very high to dissuade the FOMC from its tightening program. In addition, other major central banks are following suit – the BoE, RBA, ECB and BoC have all followed in the Fed’s footsteps and signaled their intention to tighten conditions.

Evaluation: What is currently being priced into the market?

Interest rates reflected the Fed’s hawkish stance during the quarter. According to the Eurodollar curve, the Fed Funds Rate is expected to hit 2.7% by the end of 2022, representing nine 25 basis point increases. With the FOMC now down to six meetings a year, the market is pricing in multiple meetings where the Fed will hike rates by 50 basis points. Additionally, markets are pricing in three more hikes of 25 basis points in 2023, after which the Fed will immediately begin easing policy through rate cuts.

Both the Eurodollar curve and the flattening of the yield curve point to Fed policy tightening enough to cause an economic recession. Higher returns from current levels, particularly in the middle part of the curve, would have to come from further increases in inflation – hence the importance of job vacancies and fuel price data as leading indicators of wages and CPI.

Development of the key interest rates of the Fed implied by the interest rate markets
Source: Sage, Bloomberg

In a study of the last four rate-hike cycles, we found that most negative price moves for US bonds occurred either before or during the early part of the rate-hike cycle and rebounded when the Fed ended its rate-hiking program. With the Fed officially beginning its tightening process with the first rate hike in March, we believe much of the negative yield may already be baked in.

Aggregate bond index returns during tightening cycles
Source: Sage, Bloomberg

Sentiment: What is the prevailing investor sentiment?

Investor confidence has turned straight negative as fears of FOMC tightening combined with global growth uncertainty – due to the Russia-Ukraine war, slowing China and supply-side inflation – only added more volatility to daily moves and liquidity to have. Even for one of the most liquid markets in the world – the US Treasury market – liquidity has deteriorated to its worst level since the Covid crisis, highlighting the lack of conviction in the market from both investors and intermediaries.

Bid/Ask Spread, US Treasuries (%)
Source: Sage, Bloomberg

in summary

The Fed, emboldened by elevated inflation readings, has signaled its intention to aggressively raise rates and trim its balance sheet, threatening the current expansion of the economy and reversing the positive backdrop for financial assets over the past two years. Markets, particularly interest rates, have taken the Fed’s seriousness in fighting inflation at face value and have priced in 75 basis points of additional rate hikes above the Fed’s stated final rate of 2.75%. As a result, the yield curve has flattened and the MBS basis has increased. We believe interest rates and MBS have mostly priced in the move and while credit spreads have remained resilient so far, we believe some slight widening may be warranted for corporates.

We recognize that inflation is at its highest level since the 1980s, so few market participants have experienced the current market environment. On margin, position sizes and overall portfolio risk should be lower in this environment given the unprecedented nature of the fiscal/monetary policy retreat as well as the Ukraine war overlay.


Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation to buy or sell any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data contained in this report have been obtained from and are based on sources that Sage believes to be reliable, we do not guarantee their accuracy and the underlying information, data, figures and publicly available information have been obtained from Sage not reviewed or checked for accuracy or completeness. In addition, we do not guarantee that the information, data, analysis and charts are accurate or complete and should therefore not be relied upon as such. All results contained in this report represent Sage’s opinion as of the date of this report and may vary due to various factors such as: B. Market conditions, are subject to change without notice. Investors should make their own investment strategy decisions based on their specific investment objectives and financial circumstances. All investments involve risk and may lose value. Past performance is no guarantee of future results.

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