Three Fixed Income Market Scenarios
With roughly 500 basis points of rate hikes in the rearview mirror, the Federal Reserve has enjoyed significant progress in curbing U.S. inflation. However, reducing core inflation remains a challenge and many developed market central banks have recently taken a more hawkish tone. The European Central Bank and the Bank of England, in particular, may have more work to do.
This rapid cycle of rate hikes has left government yield curves extremely inverted. Yield curves don’t stay inverted forever. Inversion tends to come before a significant economic slowdown or recession, as high short-term rates tend to lead to tightening financial conditions. But the timing and extent of this correction remains highly uncertain.
Ultra-short and short duration
Multi-Sector Fixed Income
Real GDP growth declines, but nominal GDP growth remains high. Interest rates remain elevated or even edge higher. Credit spreads widen.
We do think that interest rates are at or near their peaks at the Fed and the European Central Bank (ECB), but we do not expect them to be cut in the near future. We believe the Fed will look to maintain a real policy rate of 1 – 2% and we think U.S. core inflation will end the year between 3.5% and 4.0%. Supply shocks and higher commodity prices have been largely responsible for the price increases we have seen thus far, but wage growth and services inflation have the potential to be stickier. Mopping up the last bits of excess inflation often takes longer than clearing the more transitory drivers. We also believe long-term, structural forces, such as changing demographics, deglobalization and decarbonization, are likely to make inflation stickier than we have become used to over the past 20 years.
Shorter duration assets could have an important role to play in a ‘higher-for-longer’ rate environment. Short-duration credit, in particular, can offer investors the advantage of less exposure to volatile interest rates while giving up very little yield relative to longer-dated bonds.
While nominal growth would remain high in this scenario, it would be lower than it was when inflation was at its peak. Corporate profits may hold up relatively well, but margins and cash flows are likely to be squeezed by rising costs, including interest and wage costs, potentially widening credit spreads and rising volatility and default risk.
Multi-sector strategies which adopt a flexible approach to fixed income allocations can play an important role in this environment. Having access to the broadest possible range of markets, and the ability to make robust relative value comparisons between them, can be an advantage when it comes to diversifying exposures and finding the optimal trade-off between yield and risk. Having the flexibility to respond nimbly to evolving economic data and investor sentiment can make it easier to navigate through a volatile environment.
Short-to-moderate duration
High Yield
Multi-Sector Fixed Income
Investment Grade
Nominal GDP growth declines, but real GDP growth stabilizes. Interest rates plateau. Credit spreads stabilize.
This is the most benign, “Goldilocks” or “soft landing” scenario, where tighter monetary and financial conditions bite into inflation without inducing a major slowdown or recession. Markets bring forward their expectation for rate cuts, lowering and flattening government yield curves.
Bond investors would benefit from declining yields at both the short and intermediate parts of the curve. Corporate profits are likely to decline along with nominal growth, but positive real growth would help support demand, and relief would also come from stabilizing interest rates and other costs, helping to sustain margins, cash flow and debt repayments. This environment would be positive for credit, but the flexibility to toggle between high yield, investment grade and other fixed income sectors can help to optimize the trade-off between yield and risk as credit spreads stabilize and exhibit a bias toward tightness.
We do think that interest rates are at or near their peaks at the Fed and the European Central Bank (ECB), but we do not expect them to be cut in the near future. We believe the Fed will look to maintain a real policy rate of 1 – 2% and we think U.S. core inflation will end the year between 3.5% and 4.0%. Mopping up the last bits of excess inflation often takes longer than clearing the more transitory drivers.
Corporations have so far managed higher rates and rising costs much better than we anticipated, and this has enabled them to benefit from high nominal growth. However, with nominal growth set to decline, no relief from high rates in sight and excess liquidity continuing to drain away, we think profit margins would continue to be squeezed and that credit conditions would tighten with spreads eventually stabilizing.
When U.S. high yield spreads fall meaningfully below 500 basis points, we no longer think they compensate investors for the growing stresses we see building in some pockets of the market. Moreover, we increasingly anticipate that signs of a deepening of the economic slowdown will show up in credit markets, prompting a ‘beta-neutral’ stance. However in this environment we see a role for investment grade credit and flexible multi-sector strategies.
is largely over.
be the driver of lower inflation.
but remain stickier.
Longer duration
Multi-Sector Fixed Income
Defensive
Real and nominal GDP growth slows or becomes recessionary. Interest rates are cut. Credit spreads widen.
In this scenario, the cumulative and lagged effects of rapid monetary tightening begin to bite hard into economic growth. Unemployment rises and demand falls.
Bond investors would benefit from declining yields across the curve as markets bring their expectations for rate cuts forward. Corporate profits, margins and cash flows are likely to be squeezed and default risk would rise meaningfully. Disparities in issuer quality should become more apparent. In contrast to trends in place since the Global Financial Crisis, we believe that monetary policy will be less forgiving, reinforcing the importance of credit research and quality for bond investors.
While longer duration and defensiveness would be at the core of a successful strategy in this environment, having the flexibility to respond nimbly to evolving economic data and investor sentiment, across a wide range of fixed income asset classes, can make it easier to navigate through the volatility and take advantage of market dislocations and value opportunities.
