Fixed Income Outlook: Solutions for a New Rate Regime
Interest rates are no longer at rock-bottom levels following the brutal Q1 sell-off in fixed income. While there may be scope for a market bounce, yields typically reach their zenith much closer to the end of the Fed’s tightening cycle and not after only one rate rise. Looking ahead, investors will need to find ways to guard their portfolios from uncertainty and inflation while selectively adding risk.
Still Playing it Safe in Europe
The brutal sell-off in Q1 2022 has seen the market price in tighter central bank policy but, until there is some clarity on inflation, it will be hard to say rates have peaked. With European growth more vulnerable to high energy prices, we look at short-duration investment grade strategies to protect against rising rates.
The outlook for Federal Reserve (Fed) monetary policy dominated Q1 and drove the aggressive sell-off. While there may be some scope for a short-term market rebound, we remain cautious on the outlook for bonds. The front end forwards are well above the Fed’s current expectations for where interest rates are likely to settle – for instance, the implied 1-year Treasury rate in 1 year’s time is more than 3.25%1 , which is well above the median for the Fed’s dot plot of where the Governors expect central bank rates to rise to (2.5%). However, the FOMC’s determination of the neutral rate and how fast they are likely to get there has proved a moving target. It has largely been driven by the inflation outlook, which remains uncertain and, as illustrated by PriceStats®, is likely to remain elevated for some time to come (more on that in Theme 2).
There is currently a high degree of Fed policy tightening priced over the course of 2022; however, history tells us that the longer-term bond forward rates typically reach their peak nearer to the end of the tightening cycle, not following just one rate rise (Figure 1). The massive expansion of the Fed’s balance sheet may well have altered the reaction function of the Treasury market, but super-loose policy is set to reverse over coming quarters. In other words, the backdrop for Treasuries is likely to remain challenging.
Figure 1: The 5Y Forward Rate of the 5Y Treasury has Typically Peaked at around the Time of the Final Rate Rise
A key risk-reduction strategy is to remain in short-duration assets, with a focus on Europe. While the backdrop of high inflation is global and potentially even higher in Europe (given Europe’s dependence on Russian energy), high energy prices and sanctions will have an impact on the European economy in a way that it will not in the rest of the world. Key indicators such as the IFO Business Climate have already shown a precipitous decline. Under these circumstances, it is less likely that workers will be able to push for pay rises. A sharp slowdown should also encourage caution from the ECB. While a rate rise would have signaling power about the ECB’s intent to push inflation lower, it is difficult to see the ECB embarking on a full-blown tightening cycle in the face of a slowing economy.
Questions on how aggressively the ECB may raise rates will be answered by the data but there seems to be more agreement within the council on the need to cease bond purchases. This has been flagged as likely to occur by the end of Q3 2022 and, with bond purchases having been ongoing since early 2015, may act as a shock to the bond ecosystem. For this reason, we favour investment grade credit where far smaller amounts of credit have been purchased versus government bonds. The spread widening seen since the start of 2022 means that credit provides a yield pick-up. For instance, the Bloomberg Euro Corporate 0-3 Year Index has a yield to worst of 65bp, which, aside from the COVID spike in early 2020, is its highest since early 2016.2
It is a similar though slightly nuanced story for the UK. The market already prices more than 140bp of further rate rises from the Bank of England (BoE) for 2022.3 This comes despite the economic drag of higher energy prices, the rise in the tax burden to a post-World War 2 high,4 and the ongoing frictions from leaving the EU. If the economic data starts to soften as a result of these drag factors, then it will get increasingly difficult for the BoE to justify an aggressive path of policy tightening.
The Bloomberg GBP Corporate 0-5 Year Index also has the highest yield to worst since early 2016 (if spikes induced by the Brexit vote and COVID are excluded). While a slowing growth backdrop is not particularly constructive for credit exposures, spreads to gilts already widened at the start of the year. In addition, the buying program for credit launched by the BoE was fairly small and the fact that asset purchases have finished is likely to create more issues for the gilt market than credit.
Inflation is likely to prove persistent with increasing evidence that it is being sustained by second-round effects. TIPS can still provide a degree of inflation protection. Break-evens are wide but TIPS have proved more defensive than pure Treasuries in recent sell-offs but also showed in Q2 2021 that they can perform well in the event that the Treasury market sees a bounce.
The inflation peak remains a mirage on the horizon, pushing further into the distance the closer you get. The surge in energy prices has contributed to the latest rise in CPI and there are concerns that food will start to add pressure in a more material way, and there are also now some clear concerns over secondary effects. High energy and commodity costs have already started to feed through into manufacturing, with the US Core PCE deflator hitting 5.4% YoY in February. Tight labour markets are fueling pay settlements: the US unemployment rate declined to 3.6% in March, pretty much where it was prior to the COVID pandemic, and earnings have hit 5.6% YoY5 .
The PriceStats® indicator of inflation captures the price of many online goods. In this respect, PriceStats® is well positioned to capture price pressures in many thousands of household staple goods and prices have started to accelerate. What were viewed as one-off price increases last year are starting to repeat. This suggests that, while US CPI will eventually peak and then start to decline, price pressures could remain elevated for some time to come.
Figure 2: Longer-Term US Inflation Expectations Slowly Reverting to Higher Levels
For investors seeking to reduce exposure to persistently high inflation, an allocation to TIPS still looks appropriate:
It seems unlikely that the aggressive rise in yields that was seen in Q1 will be repeated in Q2. However, if yields do continue to rise, TIPS have proved a better place to be invested than conventional Treasuries. The Bloomberg US Government Inflation Linked All Maturities Index outperformed the Bloomberg US Treasury Index in both Q1 2021 and Q1 2022, both of these quarters saw a substantial sell-off 6. Strong flows into TIPS in Q1 suggest TIPS are regarded as being more defensive in nature than nominal bonds if it is inflation expectations that are driving the sell-off.
The longer duration of inflation-linked bonds versus the nominal Treasury means a market bounce does not automatically result in underperformance from holding TIPS. For instance, Q2 2021 saw total returns of 3.45% from the Bloomberg US Government Inflation Linked All Maturities Index against 1.75% for the Bloomberg US Treasury Index, even though break-evens were largely stable7 .
Real yields are low but have pushed around 80bp above their 2021 lows. Break-evens are already wide as they price inflation staying higher for longer, but notably the 5-year, 5-year inflation swap rate is just 30bp above its 10-year average8, suggesting the market has confidence that the Fed will get inflation back under control. If CPI remains persistently high then there may be a larger inflation premium priced into the middle part of the curve.
Assuming Some Risk via Emerging Market Local Currency Debt
Improving risk appetite, an overvalued USD and a high yield make emerging market (EM) local currency debt an option for those looking for a rebound in risk assets. While Russian bonds have now exited most indices, there remains a need to diversify risks within EM.
EM debt investors are used to idiosyncratic risk, but the Russian invasion of Ukraine had far wider implications for markets. Higher commodity prices and disrupted supply chains are seen keeping inflation high, suggesting little chance for EM central banks to start easing off the policy tightening cycle. The irony was that EM local currency debt had been doing remarkably well during the early part of the Fed tightening cycle, posting gains into mid-February 2022, while US Treasury prices were in free-fall. But reduced risk appetite, a stronger USD and a desire to divest of Russian assets have all resulted in a turn in sentiment away from local currency debt.
The backdrop could be more constructive in Q2. The rebound in equity markets suggests that the appetite for risk is alive and well. A ceasefire in Ukraine would only increase market confidence. With most fixed income portfolios enduring a rough start to the year, managers may look to increase their risk profile in order to boost returns.
The yield on the Bloomberg EM Local Currency Liquid Index is at 5.75%, its highest since early 2019. The coupon return from the exposure remains strong at 1.07% during Q1 or around 4.3% on an annualised basis9.
Currency returns for Q1 2022 were actually positive (+0.7%) largely as the commodity currencies rebounded – most notably Brazil. There was, however, a significant drag from Eastern European currencies as a result of the war in Ukraine. As of 31 March 2022, the USD was 7% overvalued relative to the basket of currencies that makes up the Bloomberg EM Local Currency Liquid Index, according to the State Street Global Advisors model of long-term currency value. A ceasefire in Ukraine would likely weigh on the USD, boosting returns from local currency exposures.
Price returns were heavily dragged down by Russian bonds getting marked to zero. Given the difficulty of trading Russian debt, prices will remain depressed for an extended period. However, that will have little effect on SPDR Bloomberg Emerging Markets Local Bond UCITS ETF given the exclusion of Russian bonds from the index and thus the fund. Indeed, if there is a ceasefire, it is likely that bonds in other Eastern European markets will bounce.
Not Entirely out of the Woods
A key issue for emerging economies is inflation. Soaring energy and commodity prices, and further disruption to the supply chains, will see inflation remain elevated. Figure 3 shows that there is already an imbalance of EM central bank rate hikers, which is high by historical standards. In other words, EM central banks have reacted aggressively to control inflation but it may be premature to call an end to the hiking cycle.
Figure 3: Emerging Market Central Banks in Policy-Tightening Mode
Figure 4: Wider Diversification has Provided Higher Returns and Lower Volatility for the Bloomberg Local Currency Liquid Index
While risks of an escalation of the war seem to have diminished, they cannot be ruled out. There is no real way to exclude geopolitical risk but the impact on fund returns can be lessened by adopting a more diversified index. Indices have become more concentrated since the end of March 2022 rebalancing with the exclusion of Russian bonds. The Bloomberg EM Local Currency Liquid Index is still relatively well diversified with 18 country issuers. The higher returns and lower volatility that this has provided over the past 5 years, relative to the JP Morgan EM local Currency indices, can be seen in Figure 4.
1Source: Bloomberg Finance L.P., as of 5 April 2022
2Source: Bloomberg Finance L.P., as of 5 April 2022.
3Source: Bloomberg Finance L.P., as of 5 April 2022.
4Source: UK OBR: Those net tax rises, plus the more tax-rich composition of economic activity that has been factored into this forecast, raise the tax burden from the 33.0 per cent of GDP recorded in 2019-20 to 36.3 per cent of GDP in 2026-27 – its highest level since the late 1940s.
5Source of data: Bloomberg Finance L.P., as of 31 March 2022.
6Bloomberg US Government Inflation Linked All Maturities Index returned -1.82% in Q1 2021 and -3.32% in Q1 2022 against the Bloomberg US Treasury Index -4.25% in Q1 2021 and -5.58% in Q1 2022. Bloomberg Finance L.P., as of 31 March 2022
7Source: Bloomberg Finance L.P., as of 5 April 2022.
8Source: Bloomberg Finance L.P., as of 5 April 2022.
9Source: Bloomberg Finance L.P., as of 5 April 2022.
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