Investor Sentiment: Unsurprisingly Volatile

This captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10 percent of outstanding fixed income securities globally.

Q1 Flows and Holdings

Turbulent times

The first quarter was a perfect storm for fixed income markets. Rather than producing a flight to safety, the Russia-Ukraine war exacerbated an already rapidly deteriorating inflation environment, which necessitated an aggressive hawkish pivot from a number of central banks, especially the Federal Reserve (the Fed). While one-year ahead expectations had already doubled between mid-December and February, they doubled again in March. The result was the worst fixed income market returns in many decades.

In response, long-term investor behavior in fixed income markets has been, unsurprisingly, highly volatile. There are, nevertheless, several important takeaways. First, the selling in the US Treasuries has been concentrated, curiously, at the front end of the curve. The implication is that long-term investors are betting that short-term rate markets have already reached a plausible peak and the damage to duration has been done. Second, there was a clear preference for European sovereign debt. Although this was focused on safe haven demand for Bunds, it also likely reflects the greater risks that European growth forecasts have been revised down further than elsewhere. Finally, and before we get too carried away with any optimism for fixed income securities, long-term investor demand for corporate bonds both in the US and euro area fell close to five-year lows, while demand for inflation protection, as observed through demand for Treasury Inflation-Protected Securities (TIPS), remained near a five-year high. The environment remains uncertain.

Treasuries, a foreign return and inflation protection

It has been a brutal first quarter for the Treasury market. Under different circumstances, the uncertainty created by international conflict would have generated a flight quality that typically would have benefitted Treasuries. But as we note in the PriceStats section on inflation, the Russia-Ukraine war has simply made a bad inflation situation worse. Although the Fed had already begun to pivot to a more hawkish stance before the war and sanctions, the rapid deterioration in the inflation picture has injected a much greater sense of urgency into the tightening cycle this year. One-year ahead market implied yields, which had already doubled from levels seen in the middle of December, doubled again in March. Given they are already at 3%, the good news is that we are reasonably confident they will not double again in Q2.

The message from the behavior of long-term investors is also somewhat reassuring. Aggregate long-term investor demand for Treasuries was, understandably, volatile across the quarter. But a sharp recovery in demand from mid-March onward left flows across the quarter surprisingly close to median levels. With quantitative tightening about to begin in earnest as soon as Q2, the resilience of this long-term investor appetite for Treasuries is highly significant. It reflects a belief that the worst may be over, something reinforced by the pattern of flows across the curve. Rather than a rush out of duration, the recovery in flows has actually been led by the demand (or at least less selling) of five-years plus. It is also notable that demand from foreign investors for Treasuries has accelerated too; it appears 2% plus 10-year yields are attractive enough relative to yields elsewhere. Finally, and perhaps one point of caution amid this modest optimism, investors are still cautious on inflation and demand for TIPS remains near five-year highs.

European divergences

The Q1 sell-off spared no fixed income markets, European sovereign debt included. As is often the case during such market dislocations, relative fundamentals tend to take a back seat. It is also likely that the true economic impact of the Russia-Ukraine war will take many months to observe clearly. Nevertheless, given the US is an energy producer and the euro area is an energy consumer (with a substantial part coming from Russia), it seems reasonable to assume that the hit to Europe’s growth outlook will be greater than the hit in the US. And while the European Central Bank (ECB) will need to respond to the rising near-term inflation threat that it faces (see PriceStats section), the required level of tightening seems likely to be much less than in the US. With a potentially weaker growth backdrop and less aggressive monetary tightening, the backdrop for eurozone bonds is potentially not as threatening in the near term. So it is notable, in a similar vein to Treasuries, that demand for eurozone bonds has been very volatile over the quarter, but has ended the quarter on a more positive note than Treasuries. The gap is not yet as wide as we saw for much of 2021, but once again it appears European divergence trades are returning.

There are some nuances to take note of within the euro aggregate. So far, the recovery in demand looks to be very Bund-centric. Flows into Spanish, Italian and even French debt have lagged — the former perhaps reflecting elevated near-term inflation concerns and the latter a pause ahead of the French presidential election. Demand for European corporate debt is also very weak, although, as we note below, this is not unique to Europe.

Appetite for riskier bonds

If demand for sovereign debt was volatile but ultimately surprisingly resilient across Q1, the same cannot be said for riskier fixed income instruments. Demand for US high yield corporate bonds fell back to its pandemic lows. It seems this not only reflects the combination of economic uncertainty and rapidly rising rate environment, but also reflects uncertainties surrounding the beginning of quantitative tightening. To the extent that quantitative easing depressed Treasury yields and pushed capital further out the credit spectrum into instruments such as high yield corporate bonds, it is reasonable to assume quantitative tightening, along with higher Treasury yields will challenge the demand for risky debt. This may not just impact credit. Demand for emerging market (EM) local currency sovereign bonds has been slow to recover since the pandemic, in part because EM central banks had already been raising rates aggressively to combat the post-pandemic inflation surge. There had been hopes that this cycle was now largely complete, but the inflation shock following Russia’s invasion of Ukraine has dashed those hopes for now as we explore further in the PriceStats inflation analysis.