Fixed Income Outlook – A Crash (At Least in the U.S.)

  • Sovereign bonds saw fastest selling in years
  • The Treasury yield curve flattened rapidly
  • US break-even rates widened amid demand for inflation protection
  • Eurozone sovereign curves steepen
  • “Peripheral” sovereign spreads widened in anticipation of a halt in ECB asset purchases.

Expect the Fed to brake harder

In the United States, inflation has spread beyond basic goods to services. Unlike the Federal Reserve, we struggle to see how inflation will soften toward its target if growth only slows toward trend. Raising policy rates to just above break-even appears insufficient to fight inflation, slow growth (thus alleviating supply bottlenecks) and ease wage pressures.

Our view is that the Fed should take rates into restrictive territory. We expect 50bp hikes for the rest of 2022. Further hikes are possible in 2023 depending on how sticky inflation is and how resilient the economy is to fallout from the Ukraine/Russia conflict. This is a much more aggressive trajectory for key rates than we had anticipated in our first quarter outlook.

We believe the Fed needs to engineer a major economic slowdown to bring wage pressures down to a level consistent with its 2.0% inflation target. Real 5y/5y forward yields are expected to increase by 75bp to 150bp. The Fed will have to tighten the monetary brake more tightly.

With respect to the Fed’s balance sheet, while efforts to return its open market portfolio to an all-Treasury portfolio could be accelerated, it is worth bearing in mind that returning the balance sheet to early 2020 (pre-pandemic) would take five to six years, and in the meantime, excess liquidity could continue to weigh on risk premia, including Treasury term premia.

On the question of how the US Treasury chooses to raise funding that would otherwise come from the Fed, we believe it is likely to steer its debt issuances into bonds – which are demanded by money market funds . In addition, demand for longer-dated Treasury bills from pension plans has been strong as plan solvency levels have improved.

Regarding the outlook for inflation, we believe that the surge in commodity prices may not be fully reversed. New inflation risks emanate from the closures in Shanghai and other major Chinese ports and cities. Soaring energy prices have highlighted the structural inflationary pressures associated with the transition to sustainable energy and the reversal of globalization. This justifies a premium in equilibrium rates.

The ECB is more cautious

In the eurozone too, the risk of higher energy and commodity prices and higher inflation is biased upwards. Inflation could accelerate to 7%-8% before falling back closer to the central bank’s 2% target in late 2023 or early 2024 as the effects of rapidly rising energy prices fade .

Looking ahead, a tight labor market and high inflation will likely support wage growth this year. However, there are downside risks. Businesses face rising input prices and margin pressures, and headwinds to growth can weaken unions’ bargaining power. The Russia/Ukraine conflict could affect growth and the labor market.

Faced with higher inflation for longer, the ECB prioritized policy normalization. Soon, however, a sense of urgency may translate into more concrete indications of when interest rates will take off.

We believe that the expectations of the ECB starting its tightening cycle in the second half of 2022 are correct. However, with data pointing to deteriorating economic, business and consumer sentiment, the ECB should be careful not to rush, especially against the Fed’s tightening path in the face of US fiscal tailwinds and pressures. more intense and endogenous inflationary.

In the short term, “peripheral” spreads in the Eurozone could underperform. Italy and Spain have less fiscal space to deal with the economic fallout from the Ukraine crisis and the end of the ECB’s asset purchase programs will leave “peripheral” bonds under pressure. In the longer term, fiscal solidarity in the EU and the ECB’s desire to combat the risk of North-South fragmentation should help contain the gaps.

On a relative basis, we expect UK gilts to outperform US Treasuries given the diverging growth outlook between the UK and US. Real income compression and central bank tightening will likely slow the UK economy, weigh on inflation expectations and reduce the need for aggressive rate hikes.

Corporate Bonds – Constructive on European High Yield

The performance of investment grade corporate bonds echoed that of previous cycles of rate hikes, underperforming in the months leading up to the first hike and continuing to underperform immediately afterwards (see Exhibit 1). This time, the underperformance was more significant due to high valuations, low spreads and the conflict in Ukraine, raising concerns about growth prospects.

Among corporate bonds, with valuations closer to long-term averages, we see room for outperformance, but as this will mainly come from the higher coupon, we are neutral in credit. Still, we expect credit to outperform government bonds from here.

In European high yield, we believe that valuations are pricing in some credit stress and that issuers’ ability to refinance debt is in question. However, we do not expect a recession and have become more constructive. Fundamentals are supportive, corporate liquidity is plentiful and we expect the default rate to remain low over the next 12-24 months.

We are more cautious on US high yield. We are wary of lower-rated bonds given the potential for interest coverage deterioration. Nonetheless, metrics remained strong and earnings reports were encouraging as companies beat (albeit lower) earnings growth expectations.

Emerging Markets – Asian Credit and Local Currency Debt

Among emerging market bonds, we are encouraged by continued support from Chinese policymakers, which should help struggling real estate developers as well as Chinese government bonds. Overall, we remain convinced that there are attractive opportunities in emerging debt.

On the hard currency front, given (the potential for) US yields to rise, we have a short duration bias.

In credit, we expect spreads to normalize in Asia. Outsized yields are likely to be driven by Asian high yield given its attractive valuations and potential for significant spread compression. We are also looking for idiosyncratic opportunities among sovereigns and corporates.

Within local currency debt, we are defensive on low-yielding issuers where inflationary pressures are building and where many central banks have already hiked rates. We believe there may still be selected opportunities to add to portfolio returns. Going forward, we expect local currency bonds to rally amid relatively high real rates.


Here are the highlights of our quarterly fixed income outlook. Download the pdf.


Warning

All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients.

The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.

Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.

Julio V. Miller