This data captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10% of outstanding fixed income securities globally.
Fixed income investors hoped that last year’s turbulence wouldn’t carry over to 2023. But monetary policy operates with long and uncertain lags. And the aftershocks of last year’s inflation surprise and hurried policy response are still reverberating through the real economy and the financial sector at different rates.
The first quarter began with robust data that called into question whether central banks had tightened enough and ended with banking stresses that seemed to suggest they had already done too much. These competing market narratives generated wild swings in fixed income market prices. However, prices that move on modest or limited flows when markets are illiquid aren’t always a good gauge of investor sentiment when markets panic.
To that end, this quarter’s Bond Compass offers a helpful window into the confidence (or lack thereof) of long-term investors. As might be expected, Treasuries, especially longer-dated ones, followed by German bunds and French OATs, saw the strongest inflows in Q1. But there are some interesting twists to this story.
In evidence of defensive behavior, flows into euro corporates were especially weak, and demand for BTPs slipped. But investors were more restrained than the panic in prices might have suggested. Demand for high yield corporate debt, for example, was below average but not markedly so — and demand for local currency emerging market (EM) debt actually improved over the quarter.
Taken together, these actions point to a measured reduction and reallocation of risk across fixed income markets, not a blind flight to quality prompted by banking sector or growth fears. It’s also telling, given the required policy response to the banking sector stresses, that demand for inflation protection remains modest. There appears to be no concern that the latest liquidity provision will reignite inflation, something our PriceStats data supports.
It was a quarter of contrasting halves for Treasuries, but not in the way you might have assumed looking only at returns. January’s stronger-than-expected jobs report and rising core PCE price index prompted a serious rethink on peak rates. Even though there was strong suspicion of seasonal distortions at play, markets and policymakers were understandably cautious about dismissing strong data as “transitory” given the mistakes made in late 2021.
Investor behavior followed a familiar pattern in response to the stronger economic news. With more tightening today meaning lower rates in the future, demand for 1-3 year segments remained close to a five-year low, while demand for 10-year bonds and longer approached a five-year high. But aggregate demand for Treasuries remained robust. Then Silicon Valley Bank (SVB) collapsed.
While investor behavior metrics outside of fixed income showed a sharp and significant reaction from investors to reduce their holdings of commercial bank equities, there was little evidence of broader contagion. In fact, inflows returned to the US financials sector by the end of the quarter.
The response of long-term Treasury investors was even more intriguing. In the 20 days after SVB collapsed, demand for Treasuries was softer, not stronger. To be clear, long-term investors were still net buyers of Treasuries, but the pace of buying over the month of March slowed to a nine-month low. This likely reflects the strong demand for longer-dated Treasuries seen earlier in the quarter, as well as investors’ significant overweight in Treasuries.
The above illustrates two things:
Figure 1: Long-Term Investor Treasury Demand Decreases after SVB Collapse
Investor behavior in Treasuries was only part of the story in Q1.
With recession risks looming, investors understandably took a cautious approach to both credit and EM sovereign debt coming into 2023. But China’s reopening story added to the better-than-expected US and European data that characterized the first half of Q1 and encouraged a bit more risk-seeking activity, at least briefly.
Interestingly, long-term investor demand for European corporates was the first to fold, perhaps on the realization that the European Central Bank still has a job to do on inflation. Demand for US corporates soon followed, and selling accelerated following the banking wobbles in mid-March, especially in riskier high yield debt.
Even if the crisis in financial market confidence appears to be contained, the real economic consequences of tighter lending standards and a higher probability of recession spell trouble for credit.
Perhaps most surprising was the relative resilience of demand for EM sovereign bonds. Having peaked in mid-February, demand for EM bonds faded, but only modestly so. Even after the collapse of SVB, flows are only slightly below average in aggregate, masking the still above-average demand for EM bonds in Latin America and Europe.
The implication? Challenges seen so far in 2023 are more of a problem for developed than emerging markets, which now show some degree of decoupling.
Figure 2: Demand for Credit and EM Sovereign Bonds Remains Resilient
The banking stresses in Q1 highlighted the media’s role in influencing expectations and actions. Thanks to our partnership with MKT MediaStats, we can measure the impact of changes in media narratives on the economy, market, and geopolitics.
Inflation has been the dominant media focus for much of the past year, as shown in Figure 3. Concurrent with a rise in the media’s coverage of recession, it underscores the continued risk of stagflation. Unsurprisingly, media mentions of deposit withdrawals are less common but began to rise rapidly in March.
Figure 3: Media Narratives Capture Market Risks
What’s important now is how quickly the bank run narrative fades and whether the coverage impacts the recession and inflation narratives.
By early April, coverage of deposit withdrawals was already at half its 18 March peak but still above average. Interestingly, though, there has been no spike in the recession narrative, nor has there been a response on inflation to the Federal Reserve re-expanding its balance sheet.1 This is encouraging to the extent that it influences consumer and business confidence and inflation expectations.
1 State Street Global Markets, MKT MediaStats, April 6, 2023.
Important Risk Discussion
The views expressed in this material are the views of State Street Global Markets through the period ended March 31, 2023. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for decisions based on, such information and it should not be relied on as such.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as “junk bonds,” is considered speculative and involves greater risk of loss of principal and interest than investing in investment-grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Investments in emerging or developing markets may be more volatile and less liquid than investments in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems that have less stability than those of more developed countries.
Investing involves risk, including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street’s express written consent.