Fixed Income Perspectives: Interest Rates Approach a Fork in the Road

The market expects the Fed to start cutting later this year

It’s been a wild ride for Fed funds expectations, as market events led to significant swings in the level of future rates (Exhibit 1). In early March, hawkish rhetoric from Fed chairman Powell caused investors to ratchet up their expectations for the level of interest rates. Shortly thereafter, the collapse of Silicon Valley Bank caused a reversal, with consensus expectations calling for rates to drop. Current expectations (represented by the blue line) show that most investors expect a steady pace of rate cuts to start later this year as the Fed attempts to maneuver a soft economic landing.

Gradual rate cuts aren’t the most probable outcome, but rather the average of two extremes

We believe it’s more likely that rates follow one of two paths. In path one, the economy holds but inflation remains stubbornly high, causing the Fed to be more patient with rate cuts than the market wants. In path two, an unexpected shock causes the economy to slow much quicker than the market expects (or wants), forcing the Fed to quickly slash rates. In our view, the average of these two scenarios threatens the consensus view of gradual rate decreases.

The case for path #1: The economy holds but rates stay higher for longer because inflation takes longer to reach the Fed's target than the market expects

Many signs point to an economy that is holding strong. In the corporate world, revenue growth and margins continue to cool, but corporations are being disciplined about taking on debt. In addition, consumers’ payment rates on credit cards are encouraging, and the labor market remains resilient. And while it’s true that inflation is certainly trending in the right direction, we believe investors are underappreciating how long it will take inflation to decline below 3%. The post-pandemic world is more inflationary, as global trade supply and demographic trends help support an environment of moderately higher inflation.

The case for path #2: While the impact to the regional banks appears to be idiosyncratic, the Fed will be in a tough spot if unexpected concerns resurface

While current economic data point to an economy that is holding strong, some leading indicators paint a less rosy picture. The senior loan officer survey historically leads loan activity by four quarters. The current survey suggests a slowdown in lending is ahead. As lending slows, the Fed will have to thread a needle to maneuver a soft economic landing. In this environment, an unexpected shock to the economy could force the Fed to aggressively cut rates. Against this uncertain backdrop, the good news for bond investors is that fixed income markets still offer very attractive yields. There is no shortage of opportunities as yields across credit quality buckets remain near 10-year highs, which will help investors navigate both paths. In a world where the Fed must aggressively cut rates, core bonds will benefit. That said, defaults will likely accelerate, and security selection is key to gaining any type of corporate credit exposure.

Investment grade
After taking advantage of recent spread widening, we’re staying liquid in the event we want to get more defensive if valuations tighten.

High yield
High yield default expectations remain low, but the trend seems to be upward.

Senior loans
We continue to look for opportunities to trade out of weaker B-rated names into higher quality single-Bs with similar yield profiles.

Securitized credit
We are cautious on CMBS as the banking crisis is likely to accelerate de-leveraging in commercial real estate.

Agency RMBS
Near-term performance should remain highly correlated to moves in rate volatility and money manager fund flows.

Emerging markets
Asset prices are largely being driven by external factors, a dynamic that is likely to remain true as it was for most of 2022.

Global rates and currencies

• The Fed is walking a tightrope as it weighs the risk of sticky inflation versus the potential for slower-than expected economic growth from reduced lending.
• In the Eurozone, the hawks appear to have the upper hand within the ECB given the growth boost from a better-than-expected-winter.
• Additionally, unlike the Unites States, it’s less clear that inflation in Europe has reached its peak.

Investment grade corporates

• Investment grade (IG) spreads widened 40 basis points (bps) in the middle of March after three major banks failed in the United States, forcing regulators to step in and the Fed to introduce new lending facilities to shore up liquidity and confidence in the banking system.
• Ultimately, the market did not view the situation as systemic, and buyers emerged at wider levels, driving the index OAS back to +138 by month end.
• We used the volatility to selectively add to IG credits and see additional room for spreads to tighten from current levels.

High yield corporates

• As we’ve expressed in the past, over the longer term the main driver of the sector will be the strength of the recession, should a slowdown materialize. The market is pricing in a slowing economy, but not a severe weakening.
• High yield default expectations remain low, but the trend seems to be upward.
• We’re overweight building products and independent energy; underweight financials and telecommunications.

Senior loans

• While senior loans have become more heavily correlated to movements in macro sentiment than is typical for the asset class, all eyes are on first-quarter earnings.
• We have a bias towards the packaging, restaurants, and gaming/leisure sectors.
• We are cautious on cyclical sectors or those reliant on discretionary consumer spending. We also continue to maintain a cautious stance on the telecom, communications and technology sectors.
• We continue to look for opportunities to trade out of weaker B-rated names into higher quality single-Bs with similar yield profiles—executing this strategy has become more challenging given the accelerated softness in lower-rated loans and increased dispersion.

Securitized credit

• In CMBS, where regional banks are major players, delinquencies are inching up and current spreads reflect these concerns.
• In the short-term, spread widening in CMBS, while not yet buyable in our view, should attract buyers and deter enough sellers to allow the space to stabilize. Longer-term, we are cautious about the CMBS space and have downgraded our view to negative as the banking crisis is likely to accelerate de-leveraging in commercial real estate.
• In the short term, we maintain our positive outlook on CLOs. Longer term, we remain cautious as our main concern is the potential for fundamental economic weakness.
• We continue to be positive on RMBS, given the fundamental strength of the housing market.
• We remain positive on consumer ABS as new issue supply is modest, and most consumers remain financially healthy.

Agency RMBS

• March prepayment speeds are expected to increase, while net issuance in 2023 is expected to be near the $550 billion of supply we saw in 2022.
• Near-term performance should remain highly correlated to moves in rate volatility and money manager fund flows.
• Longer-term, slower economic growth should provide a boost in demand for government guaranteed agency RMBS. However, an imbalance between supply and demand could weigh on the space if supply surges and bank demand fails to emerge.

Emerging market debt

• In March, emerging market (EM) asset prices were largely driven by external factors. Going forward, this dynamic is likely to remain true as it was for most of 2022.
• The US growth outlook is now the primary driver of EM performance and downside risks have increased following recent banking stress.
• China’s reopening appears to be maintaining its momentum driven by the service sector and a bottoming of the housing market.
• In commodities, recent decisions by OPEC to decrease output should offset signs of weak demand and provide a floor to oil prices at levels that are supportive for exporters.