Our latest Fixed Income Investment Outlook coincides with a dramatic period in rates and credit markets.
Last week saw the 10-year U.S. Treasury yield drive through the 2.7% threshold. The yield curve inverted—and then steepened again—at the closely watched two- and 10-year points. On Wednesday, the minutes from the Federal Reserve’s March meeting revealed new details of its plan for balance sheet reduction.
Meanwhile, credit spreads remain elevated and volatile as investors continue to assess the economic impact of tightening policy and the conflict in Ukraine.
How do we see these themes playing out over the next 12 months?
We now expect the Fed to hike rates by 50 basis points in both May and June, followed by a sequence of 25 basis point hikes until the policy rate approaches meaningfully restrictive territory. Given the strength, persistence and broadening of inflation, we think that terminal rate looks likely to be close to 3.5%.
This is in line with market expectations, which we think may be reaching a peak.
Our colleague Joseph Purtell has already outlined our key takeaways from the Fed’s March minutes. Here, we would highlight how soon the central bank plans to begin reducing its balance sheet, and how quickly it plans to proceed once it gets going. At a pace of perhaps $95 billion per month, it would be on track for a multitrillion-dollar reduction over the coming years.
We believe this is significant. Balance sheet reduction is not as effective a tool for fighting inflation as rate hikes, but it is important. So, when we think of the Fed combining those tools in pursuit of its price-stability mandate, a faster pace with one may imply an easier pace with the other.
That may be why market rate expectations declined slightly after the minutes came out—and why the yield curve re-steepened after briefly inverting.
Some analysts regard yield curve inversion as a signal of a coming recession. We generally don’t see it that way, and we are particularly skeptical on this occasion.
In our view, the relatively high two-year yield reflects the aggressiveness of the Fed’s proposed hiking cycle, while the long end of the curve remains depressed by quantitative easing, and by demand from institutional investors and overseas buyers of attractive hedged dollar yield. Moreover, the curve remains steep at points other than two and 10 years, and the real yield curve is also both steep and, at negative rates, quite stimulative.
With that in mind, market moves following the Fed minutes may reflect reassurance about the central bank’s ability to use both rate hikes and balance sheet reduction to bring prices back under control without inflicting excessive collateral damage on the economy.
We think that fits with our view on economic fundamentals.
U.S. unemployment is almost back to pre-pandemic levels and the consumer remains in excellent shape. Household debt levels are close to record lows and savings remain high. This is also broad-based, with lower- and middle-income earners seeing particularly solid wage gains and wealth creation.
Overall, we think that makes for a considerable cushion to absorb both inflation and the policy-tightening necessary to curb it. We therefore anticipate slowing U.S. growth over the next 12 months, but not a recession. We see the risks growing on the two-year horizon, but remaining below our threshold for concern.
Our Outlook sets out more detail on what we think that means for fixed income investment strategies, but these are the headlines.
With rate expectations peaking, we believe volatility in Treasury markets will begin to ease. We may see more curve-steepening from here.
That, together with the robustness of the economy, provides a good foundation for credit, in our view. With both high yield and investment grade spreads pricing at near-recession levels, we see attractive value opportunities in a range of sectors.
Volatility is likely to remain elevated compared with 2021—we suspect the inflation data has yet to peak and could still generate some concern. But as investors continue to digest the likely path of this tightening cycle, we think the dramatic moves of recent weeks are set to ease.
In Case You Missed It
- ISM Non-Manufacturing Index: +1.8 to 58.3 in March
- China Composite Purchasing Managers’ Index: -6.2 to 43.9 in March
- Eurozone Producer Price Index: +1.1% in February month-over-month and 31.4% year-over-year
What to Watch For
- Tuesday, April 12:
- U.S. Consumer Price Index
- Wednesday, April 13:
- U.K. Consumer Price Index
- U.S. Producer Price Index
- Thursday, April 14:
- European Central Bank Policy Meeting
- U.S. Retail Sales