Market Commentary | April 8, 2022

At Last—Income in the Fixed Income Market

The first quarter was brutal for fixed income investors. Rising interest rates, spurred by surging inflation and a sharp turn toward tightening by global central banks, sent prices down and yields up. It was one of the worst quarters for fixed income in decades.

Rates are higher across most of the curve

Source: Bloomberg, The change in yields from 12/31/2021 to 4/4/2022. A basis point is 1/100th of a percent, or 0.01%. Past performance is no guarantee of future results.

 

As painful as it was, we see the selloff creating opportunities for investors. The steep rise in yields should mean that income investors can finally earn relatively attractive yields in the bond market after enduring nearly three years of near-zero interest rates. While it may seem counterintuitive to buy bonds just as the Federal Reserve embarks on a policy tightening path, we believe that much of the bad news is already discounted. The risk/reward in segments of the bond market has improved significantly. 

Market has priced in a fast, steep tightening cycle by the Fed

A lot has changed in the past few months—mainly the Federal Reserve's policy stance. Until December, the Fed was focused on the potential negative economic fallout from the pandemic and was cautious about exiting its very easy policy stance. The stronger-than-expected recovery, along with the spike in commodity prices due to Russia's invasion of Ukraine, forced the Fed and other central banks to shift toward tighter policy. Consequently, yields jumped across the curve, led by a steep rise in short-term rates.

Yield curve snapshot

Chart shows the three-month to 30-year yield curve as of April 4, 2022, December 15, 2021, and April 2, 2021.

Source: Bloomberg, as of 4/4/2022, 12/15/2021 and 4/2/2021.

 

Yield curve signals

The market is now discounting a fast pace of Fed rate hikes, with the federal funds rate expected to reach as high as 3% in early 2023. Considering that the Fed has only raised rates once, a lot of future rate hikes are already being discounted by the market. It's important to note however, that the market is also discounting a few rate cuts in 2024. 

Yields are now converging between two-year to10-year maturities. They are currently above the Fed's longer-run estimate of the "neutral rate" of about 2.5%—the rate that is low enough to support economic growth but high enough to keep inflation in check. In past cycles, when the yield curve flattens near the neutral rate, it has been near the peak in long-term rates.

The spread between two-year and 10-year Treasury yields has narrowed 

Chart shows the yield difference between 2-year and 10-year Treasuries. The spread has narrowed from nearly 160 basis points in early 2021 to 2 basis points as of April 5, 2022.

Note: The rates are composed of Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current two-year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. Past performance is no guarantee of future results.
Source: Bloomberg. Daily data as of 4/5/2022.

 

In the past few weeks, parts of the Treasury yield have inverted. Ten-year yields are lower than five-year yields, and the much-watched two-year/10-year yield spread dipped into negative territory briefly. Yield curve inversions raise concerns because they have historically preceded recessions. 

However, the Fed watches short-term rates more closely. Fed Chair Jerome Powell indicated that the "near-term forward spread" is a key indicator for Fed policy makers. The spread is the difference between the current three-month T-bill yield and where the market is pricing the expected three-month yield 18 months from now. That difference is still very wide, signaling that the Fed has ample room to raise rates. 

The near-term forward spread remains steep

The near-term forward spread has widened to more than 250 basis points as of April 5, 2022. That is substantially steeper than its level in October 2021, when it was below 50 basis points.

Note: The near-term forward spread is the spread between the yield on a 3-month Treasury bill and a 3-month Treasury bill 18 months from now.
Source: Bloomberg. Fed Near-Term Forward Spread (FEDNTFS Index). Daily data as of 4/5/2022.

 

When the near-term forward spread starts to narrow, the Fed is likely to slow its pace of tightening. The faster the Fed moves in the short run to get near its neutral rate, the more likely it is that the spread will flatten or narrow. 

The Fed is also expected to announce it will begin reducing the bond holdings on its balance sheet in May. This process—known as quantitative tightening or QT—is another way for the Fed to tighten policy by reducing the flow of liquidity to the financial system. 

What about inflation?

The biggest concern for fixed income investors is inflation. Although it's likely to remain high in the near term due to rising commodity prices, we expect it to ease later in the year—providing some relief for bond investors. The economy is showing signs of cooling off after a sharp rebound from pandemic lows. It appears that a lot of consumption was likely pulled forward by the combination of easy fiscal and monetary policies last year. Now the pace is moderating, especially in key areas where in financing costs are rising—like capital expenditures and housing. 

The pace of core capital goods orders is slowing

Chart shows monthly capital goods new orders (non-defense and ex-transportation) from February 2017 to February 2022. Orders rebounded in 2020 after an initial post-pandemic drop, but growth has since leveled off and slowed.

Note: This concept tracks the value of new orders received during the reference period. Orders are typically based on a legal agreement between two parties in which the producer will deliver goods or services to the purchaser at a future date.                                                                              
Source: Bloomberg. Capital Goods New Orders Non-defense Ex Aircraft & Parts. Monthly data as of 2/28/2022.

 

The housing market is feeling the pinch of higher interest rates. Mortgage applications for purchases and refinancings have dropped sharply and new home sales have fallen from peak levels of 2021. It appears that the housing boom may be over. Since a lot of consumption has been tied to the housing market, the slowdown is significant. 

Mortgage applications drop as mortgage rates move up

Chart shows the percent change, four-week moving average, of mortgage applications from March 2018 to March 2022, along with the 30-year average fixed mortgage rate. Mortgage applications have dropped from levels seen in 2021.

Source: MBA mortgage applications (MBAVCHNG Index) and Freddie Mac Primary Mortgage Market Survey, U.S. 30-year FRM. Monthly averages as of 3/31/2022.

 

Long-term inflation expectations have increased only modestly

You wouldn't know it from reading the financial news or listening to the most hawkish central bankers, but inflation expectations appear reasonably contained. The markets are discounting high inflation in the near term, but also an aggressive tightening cycle that will pull it lower longer term. 

The University of Michigan consumer sentiment survey indicated that near-term inflation expectations are high and continue to rise. Not surprisingly, short-term inflation expectations tend to be highly correlated with oil and gasoline prices. However, despite the steep rise in prices recently, five-to-10-year inflation expectations are sitting at 3%, which happens to be the long-term average dating back to the 1990s. In other words, consumers don't expect this inflation spike to last at the elevated rates we've seen recently.

Short-term inflation expectations the highest level since 1981, but long-term inflation expectations remain near 3%

Chart shows 1-year inflation expectations and 5-10 year inflation expectations. One-year inflation expectations were at 5.4% as of March 2022, and 5-10 year inflation expectations were at 3%.

Source: Bloomberg. University of Michigan 1-year inflation expectations (CONSEXP Index) and 5-10 year inflation expectations (CONSP5MD Index). Monthly data as of March 2022.

 

Inflation is a policy choice, and the major central banks are choosing to bring it down. This is probably one of the most important considerations for investors right now. In major countries with independent central banks, inflation is the result of policy decisions. Central banks have the tools to target an inflation range. Currently, central banks around the globe (with a few exceptions like Japan and China) are choosing to drive inflation lower. Even Europe, where the war in Ukraine is having a negative impact on growth, tighter monetary policy is in the works.

In the U.S, the Fed has clearly signaled it wants inflation to come down and will do "whatever it takes" to lower it. The Fed can't do much about the supply side shocks lifting inflation, but it can depress demand. To achieve a more stable supply/demand balance, the Fed's focus will be on creating "slack" in the economy. By raising the cost of money and reducing reserves in the banking system, the Fed can slow growth. That probably means higher unemployment on the horizon as slower consumer spending and capital investment mean fewer jobs. Since inflation is a lagging indicator, the impact of the tightening now is likely to show up in the next six to 12 months. 

Opportunities for income

We are finally getting positive on the outlook for intermediate to long-term bonds. After spending the better part of the past few years suggesting investors keep average portfolio duration low due to the risk of rising yields, we are now in favor of adding duration (that is, some slightly  longer-term bonds), and selective credit risk. What changed? Yields and the stance of Fed policy. 

The risk/reward has improved now that yields have jumped up and the signs from the yield curve suggest the peak in yields for the cycle may be getting closer. There may be some more upside in yields if inflation proves more stubborn than we expect, but with the Fed all-in on bringing it down and the curve flattening, the collective wisdom of the market is suggesting that yields are likely to plateau or move down.

Yields aren't as low as many investors likely assume

Chart shows average yield for a variety of fixed income asset classes. High yield corporates' average yield was 6.2% as of March 25, 2022, while preferred securities' average yield was 4.9%, the U.S. Agg yield was 3%, and Treasuries yielded 2.5%.

Source: Bloomberg, as of 3/25/2022. Indexes represented are: HY Corporates = Bloomberg U.S. Corporate High-Yield Bond Index; EM USD Bonds = Bloomberg Emerging Market USD Aggregate Index; Preferreds = ICE BofA Fixed Rate Preferred Securities Index; IG Corporates = Bloomberg U.S. Corporate Bond Index; MBS = Bloomberg U.S. MBS Index; U.S. Agg = Bloomberg U.S. Aggregate Bond Index; Municipal bonds =  Bloomberg U.S. Municipal Bond Index; Treasuries =  Bloomberg U.S. Treasury Index; and Dividend Aristocrats =  S&P 500 Dividend Aristocrats Index. Yields shown are the average yield-to-worst, except for the Dividend Aristocrats which is the average dividend yield. Past performance is no guarantee of future results.

 

Risks to our outlook

Inflation and growth could continue to surprise on the upside, causing estimates of the “neutral rate” to rise. It's more likely to happen if central banks turn cautious and don't follow through on tightening than if they continue to be hawkish. Watch what happens in the yield curve for signs of any slippage in expectations. It would show up in a steeper yield curve and rising inflation expectations.

The other caveat is that while nominal yields have risen sharply, real yields are still low or negative. We expect real yields to rise as the Fed tightens and inflation expectations subside. But it would make us more comfortable to see real yields in positive territory as a starting point. Consequently, we're constructive but focused on seeing inflation cool off later in the year to validate our market expectations.

Real yields are still negative

Chart shows the real, or inflation-adjusted, neutral rate of interest since February 1998, as well as the real 10-year Treasury yield. The real 10-year yield has been below zero, or negative, since the pandemic began in early 2020.

Source: Federal Reserve and Bloomberg. D'Amico, Kim, and Wei Model, U.S. Real 10-Year Treasury Yield Using TIPS Breakevens, and U.S. Recession Index (USGGT10Y Index, USRINDEX Index). Daily data as of 2/28/2022.

 

Nonetheless, we are growing more constructive on the fixed income market for the first time in a few years. It may be a bumpy ride, but current yields in many areas of the market are high enough to make taking more duration and/or credit risk worthwhile.

Look for opportunities

We suggest investors gradually begin to increase the average duration in their portfolios as yields move higher. For income investors, we favor investment grade corporate bonds and preferred securities. At current yields, we believe the risk/reward has improved considerably. Investors in higher income brackets should consider munis since credit risk remains low in our view and the recent rise in yields has substantially improved valuations. 

As the cycle of tightening global liquidity plays out, we suggest being cautious about riskier segments of the markets. Central banks are trying to tighten financial conditions to reduce inflation and that is often associated with greater volatility in lower credit quality, less liquid markets.
 

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