Fixed Income Update: Bonds to shine in 2023 as the U.S. economy slows and the Fed moves into a risk management mode
Market Strategist, Greater China
摘要: After chasing the runaway inflation train from behind for eight months and signs of economic slowdown emerging, the Fed is ready to adjust its pace to a lower gear in 2023 and move into a risk management mode and become data-dependent. As a downturn in the economy and the impacts of past rate hikes continue to haunt equities and high-year credits, U.S. treasury notes and investment-grade bonds are increasingly valuable to an investment portfolio in providing it with yields and potential risk reduction.
Bonds did not work in the past 12 months but things are starting to change
For the best part of 2022, the prices of equities and bonds fell together, and the 60-40 portfolios performed poorly. Bonds have not been able to perform the function of mitigating the risks of stock market selloffs. The primary reason for this phenomenon was that the decline in equities resulted from higher interest rates, which also drove bond prices down. When inflation was the problem, both equities and bonds tend to fall together (Figure 1). When inflation starts to plateau and the number one concern of the markets is shifting from inflation to deceleration in growth, which was the result of the aftermath of past aggressive rate hikes to fight inflation, equities and bonds tend to behave differently, with bond prices rising as equities declining. This potential shift in the equity-bond dynamic makes bonds a valuable asset class to be included in an investment portfolio in the coming months.
The Fed‘s modus operandi has shifted from chasing a runaway inflation train from behind to data-dependent risk management
The US inflation train left the station in March 2021 (Figure 2) but the Fed waited for a full year before they raised the policy interest rate for the first time in March 2022. The inaction of the Fed from March 2021 to February 2022 (red zone in Figure 2) and its now infamous notion of the transitoriness of inflation put the Fed in an awkward position of chasing the inflation train from behind (the blue zone in Figure 2). The Fed started small in March 2022 and then quickly abandoned its initial gradualism and rushed to the new normal of 75bps rate hikes four times in a row since June 2022.
During this phase of chasing from behind, the rate of change in inflation have decelerated and the inflation rates seem to have plateaued at elevated levels. The distances between inflation rates and the Fed Fund target rate are converging. This development provides the Fed with some breathing room to consider slowing from the turbo-charged pace of monetary tightening to a lower gear.
The Fedspeak over the past two weeks and the minutes of the FOMC’s November meeting provide investors with a gap in the curtain to gauge the new phase of risk management in which the Fed’s pace of tightening and the terminal rate are becoming more data-dependent. According to the minutes, participants of the FOMC’s November remarked that:
purposefully moving to a more restrictive policy stance was consistent with risk-management considerations…There was wide agreement that heightened uncertainty regarding the outlooks for both inflation and real activity underscored the importance of taking into account the cumulative tightening of monetary policy, the lags with which monetary policy affected economic activity and inflation, and economic and financial developments.
Minutes of the FOMC Nov. 1-2, 2022, p.10
Inflation, especially services inflation, is still sticky but after raising its policy overnight Fed Fund rate target from 0.00-0.25% range to 3.75-4.00% in eight months, the Fed is finally signaling its intention to reduce the size of future rate hikes starting probably from December and adopting a data-dependent risk management approach going forward. It is important to reiterate here that the change in the Fed’s thinking and approach does not mean that the Fed is pivoting in the sense of having decided to end the current tightening cycle. The Fed needs time to allow the impact of the rate hikes over the past eight months to come about as monetary policy working with lags. In addition, the Fed needs time to assess the impact of the quantitative tightening as it winds down its balance sheet.
The market is already signaling to the Fed that the latter might have overdone the monetary tightening and could trigger a recession next year. The long end of the curve has been well bid with the 10-year yield falling to 3.69%, 65bps below its cycle high of 4.34%, and the 30-year yield declined to 3.73%, 69bps off its high of 4.42%, despite that the Fed raised its policy rate by 75bps since then. Short-term interest rates were driven by the Fed’s actions to raise the overnight Fed Fund rates while longer-dated bond yields fell on the prospect of slower growth or even a recession together with anchored long-term inflation.
The market is signaling recession risks
The yield spread between the 3-month treasury bill versus the 10-year treasury note tumbled to minus-63 (Figure 4), a level only seen in less than 12 months preceding the prior three recessions. According to the New York Fed’s study, the 3-month vs 10-year yield curve is the preferred indicator to the more popular 2-year vs 10-year yield curve to foretell a recession. We at Saxo are not calling for a U.S. recession as our base case for 2023 but we are expecting growth to decelerate and the risk of the U.S. economy dipping into recession is not negligible.
While none of the members of the FOMC mentioned the “R” word as per the November minutes, the Fed’s staff economists in their assessment of the economy presented to the FOMC suggested that “the possibility that the economy would enter a recession sometime over the next year as almost as likely as the baseline” projections.
The inflection point may be near for bonds to contribute positively to the portfolio while equities slide lower as the economy and corporate earnings growth slow
The past 375 bps increase in the policy rate have been working through the financial markets and the economy. Although not yet fallen into a recession, the U.S. economy has shown signs of slowing and companies are reporting weaker outlooks for their businesses. Analysts are revising down Q4 and 2023 earnings forecasts for companies other than those in the energy sector. In short, the equity market is facing multiple headwinds. After six rounds of increases and 375bps in total, the financial condition in the U.S. arguably has not yet entered into the restrictive territory. For example, the Chicago National Financial Conditions Index is still below zero, the threshold between tight (above zero) and loose (below zero) financial conditions (Figure 5). The Chicago National Financial Conditions Index is compiled from 105 financial indicators including stock prices. As equities may retreat on recession fear, margin compression, and earning downgrades, the proverbial Fed put for the equity market is nowhere in sight to bail out equity investors in case of a selloff. The carry or coupon income of bonds and potentials of capital appreciation (bond prices rise when yields fall) will be something very valuable to have in a portfolio to generate positive returns and reduce volatility as the Fed has likely moved past the chasing inflation from behind phase.
The 3 to 7-year segment of the U.S. dollar yield curve tends to offer relatively better risks and rewards through Q1 2023
From the closing of Nov 1, 2022, the day before the FOMC decisions on Nov 2, to the present, yields for the short-dated bills through 1-year bills rose and yields for 2-year notes little-changed and those for 3-year notes through 30-year treasury bonds declined significantly (Figure 6).
As the Fed is not done yet with rate hikes but only adjusting its pace, the short end of the curve through 2-year notes is likely to continue to rise or little-changed at best to reflect the Fed’s rate hikes. On the other hand, yields from 3 years onward may be poised to fall to reflect the outlook for an anchored long-term inflation rate (Figure 7) and deteriorating growth and recession risks.
On the balance of yields, potential capital gains, and duration risks, the 3-year to 7-year segment of the curve looks relatively attractive. It is important to note that while the yield curve tends to become increasingly inverted months ahead of a recession, it will steepen and turns positively sloped again shortly before the onset of a recession and through the recession and the subsequent recovery (Figure 8). For traders who are taking a punt in the market, the long ends may still be the place to be in. However, for investors who are looking for yields, long-term capital appreciation, and reducing risks for their portfolios for 2023, the 3-year to 7-year treasury notes may be the better place to be in. Moreover, after the recent sharp decline in yields, it may pay off for investors to be patient and wait for yields to bounce before gradually adding bonds to their portfolios through the first quarter of 2023, as opposed to taking a large position in bonds in one go at the current yield levels.
Sticking to investment grades until deep into an economic downturn or the onset of a recession
In addition to selecting the tenor of bonds to invest in, investors have many alternatives in terms of credit quality. As a rule of thumb, bonds with better credit quality tend to yield less, and bonds with lesser credit quality tend to offer investors higher yields. One of the key factors for investors to consider is if the additional yields are compensating more than sufficient for the higher credit risks embedded in a bond. Credit risks are more than just default risks. Only considering whether a certain issuer will default or not is insufficient. For example, a deterioration in an issuer’s cashflows to cover interest payments may cause a downgrade in credit rating which in turn adversely affects the price of all the bonds issued by that company. Another factor to consider is the likely direction of change in credit spreads in general. For example, when the economy is entering into a recession, corporates in general tend to suffer from deterioration in cashflows and therefore lower creditworthiness for the issuers and wider credit spreads for their bonds. Credit spreads, in a sense, is a put option on the issuing company. Investors pick up an option premium (credit spread) on top of a risk-free rate (treasury yield) when investing in a corporate bond. In an economic downturn that causes equity volatilities to surge, credit spreads widen.
As the U.S. economy is likely to slow down sharply or even enter into a recession, investors shall demand an above-average credit spread from high-yield bonds to compensate for the risks. Currently, U.S. high-yield corporate bonds on average are yielding 305 bps more than investment-grade bonds which are much lower than what they were during past recessions (Figure 9). In other words, high-yield bonds are not offering sufficiently attractive yields relative to investment-grade bonds given the stage of the business cycle we are in. Better buying opportunities will emerge in high-yield corporate bonds when the U.S. economy slips deep into an economic downturn or at the onset of a recession when bad news and pessimism hit and credit spreads become excessively wide and more than sufficient to compensate for the embedded risks.
Regarding credit trends, it is noteworthy that among all the rating actions by Moody’s in October, credit upgrades accounted for just 42%. It was the first time in two years that Moody’s downgraded more issuers than upgraded. Likewise, U.S. banks were tightening lending standards. Increased difficulties in getting bank financing will take its toll on the corporate bond markets. Therefore, it is advisable to stick to investing in investment-grade bonds.
Taking profits in the short position in the September 2023 3-month SOFR futures (SR3U3)
As the Fed has moved into a risk management mode and the pace and path of monetary policy have become data dependent, investors who have taken a short position at around 97.20 in the 3-month SOFR futures September 2023 contract (SR3U3) that we noted on August 1, 2022, when the market underestimated the magnitude of incoming rate hikes from the Fed and prematurely priced in rate cuts in 2023, may consider taking profits. Although we still think inflation will be sticky and stay at elevated levels and the Fed is not cutting rates in 2023, the current level of SR3U3 at 95.185, which represents a 3-month (from Sep 20 to Dec 20, 2023) compound rate of the secured overnight financing rate at 4.815%, offers diminished upside on risks and rewards. On September 22, after the Sept FOMC meeting, we lowered our target of the trade to 95.25 (or 4.75%). The target is now reached and taking profits deems appropriate.
- The Fed has shifted to a risk management mode
- The pace and path of the Fed’s rate hikes in 2023 will be data dependent
- Equities are facing headwinds as the economy slipping into a sharp downturn or even recession
- Bonds are becoming attractive in providing yields and potentially reducing volatilities in an investment portfolio in 2023
- Focussing on 3-7 year U.S. treasury notes or investment-grade corporate bonds
- Avoiding high-yield (non-investment-grade) bonds until deep into the economic downturn or onset of recession at credit spreads much wider than the current level in the second half of 2023
- Taking profits in the short SOFR futures