The market’s curve flattening expectations may be excessive, as the timing of the hikes and aggressiveness of the U.S. Federal Reserve are still open to debate.
Interest rates continued their rollercoaster in the final quarter of 2021 and into the first few weeks of 2022. After settling at flat levels for the fourth quarter, yields spiked higher to start the new year, with the 10-year U.S. Treasury yield reaching as high as 1.90% intra-day before settling slightly lower. While increases in short-term rates continued – as the market is now pricing in four fed-funds rate hikes – we believe the Fed will remain cautious and data-dependent to avoid an economic slowdown. As such, we think three to four hikes this year is a fair expectation, while anticipating the start of the balance sheet reduction to occur in May.
Given our Fed policy outlook, we expect moderate pressure for the 10-year yield to move higher throughout 2022, but we believe the market will resist moving significantly above 2%. In terms of curve shape, we do not expect the curve to flatten as much as priced into forward curves, and the path is likely to be volatile with the timing of hikes and aggressiveness of the Fed still open to debate. Global inflation, accentuated by energy and commodity prices, is likely to peak in early 2022 but the rate of decline will likely vary across economies. Inflation in the U.S. will decline only gradually and likely remain above the Fed’s target, as wage-driven services inflation and continued rising shelter costs offset a retracement in Covid-driven goods inflation.
In this environment, corporate and consumer fundamentals should remain strong and justify valuations remaining at historically “fully-valued” levels, with episodes of volatility creating tactical opportunities and anchoring our preference for credit sensitivity over rate sensitivity in portfolios. As a result, we remain underweight U.S. Treasuries and agency mortgage-backed securities (MBS), while allocating risk across the corporate and securitized credit spectrum. The first Fed rate hike is a limited risk to credit markets, as credit spreads have historically held steady and even narrowed in the early stages of a Fed hiking cycle. At the same time, we are mindful of the limited upside available, which increases the need for downside protection beyond the traditional duration toolkit. Further out, as U.S. rates reach an equilibrium and U.S. dollar strength abates, emerging market debt securities could prove attractive.
Bond Market Outlook
Global Rates: Yields to edge higher driven by ongoing inflation worries and 2022 rate-hike expectations
Global Currencies: U.S. dollar to remain range-bound as market balances global Covid concerns, hawkish central bank policies
Investment Grade: Despite a heavy January new issue calendar, the tone for IG looks favorable to start the year
High Yield: The year-end rally has valuations elevated in the new year; strong inflows stand ready to absorb a hefty calendar
Securitized: Prefer areas in CMBS and CLOs where yield opportunities remain; residential credit still facing prepayment headwinds, but outlook is positive
Emerging Markets: Growth remains positive even if pace of developed market growth fades, but still asynchronous amid supply chain uncertainties and rebound in trade
As of 12/31/21. Source: Bloomberg, Bloomberg/Barclays, JP Morgan and Voya. Past performance is no guarantee of future results.
Global Rates and Currencies
With growth momentum strong, supply chain pressures easing, broad-based wage gains, and Omicron data from South Africa and the United Kingdom suggesting that the Covid variant is less severe, we see plenty of reason for optimism. However, with liquidity removal from central banks underway, fuel prices surging in Europe, delays in fiscal stimulus, and wage-price pressures persisting, caution is warranted. Indeed, the risks we’re keeping a close eye on include supply chain bottlenecks persisting, the labor force participation rate remaining low, and another Covid mutation. Furthermore, lower potential growth may exacerbate fiscal cliff issues.
The U.S. remains the leader in growth among major economies, due in part to less stringency on lockdowns and a general willingness by consumers to largely maintain activity levels despite Covid concerns. On the monetary policy front, the Fed is looking to normalize monetary policy, and the market is solidly pricing in four fed-funds interest rate hikes in 2022, likely starting in March. At this point, some form of decision on balance sheet run-off is priced in – which along with investment grade credit issuance – has led the U.S. Treasury curve to steepen. In our view, the Fed would like to hike at least two times before allowing for balance sheet run-off to occur. Meanwhile, quantitative tightening will have more of an impact on risky assets than an impact on the Treasury curve, in our opinion. On the fiscal side, the expiration of the child tax credit and the lack of other new spending we had been expecting will likely reduce the fiscal impulse to growth by around 1% in the first quarter of 2022, 0.5% in the second quarter, and 0.25% in the third quarter.
In the European Union, just like the Fed and the Bank of England, the European Central Bank was hawkish relative to expectations. This has put upward pressure on peripheral yields and those of core European government bond. More broadly, we expect the EU to outperform the U.S. in growth terms for two primary reasons: NextGenerationEU disbursement is likely to be heavy in 2022, so fewer fiscal cliff concerns than the in U.S.; and goods consumption has lagged in Europe, so there is room for pentup demand.
Investment Grade (IG) Corporates
Investment grade spreads rebounded 7 basis points (bp) in December, finishing the year just 4 bp tighter and generating 161bp of excess return for the period. As fears around Omicron subsided, strong year-end technicals supported spreads. We took advantage of the widening by adding IG across strategies and now see levels as more balanced. Despite a heavy January new issue calendar, the tone for IG looks favorable to start the year, with higher yields and lower hedging costs attracting buyers. The fundamental picture should continue to be supportive as 4Q21 earnings begin. Corporate option-adjusted spreads are back in the middle of the six-month range, so valuations look less interesting, but might have some room for further compression as investors look to put on positions in the new calendar year. Thus, we move our tactical rating back to neutral, from neutral/positive. We continue to see the most value in seven- to 10-year bonds with the long-end of the Treasury curve flattening. Sector wise, we like telecommunications, utilities, and technology.
High Yield (HY) Corporates
High yield ended 2021 on strong note, bouncing back from the November sell-off with solid performance across the ratings spectrum. However, the end-of-year rally left little room for a continuation thus far in in 2022; valuations are back to uncompelling levels. Nonetheless, while some cash did build due to the strong inflows and light new issuance volume in December, a reasonably heavy calendar awaits. Also, while equity valuations remain mostly supportive, there are some pockets of excess that the market needs to wring out eventually, and HY will likely feel some of that pain. More broadly, we still caution that the big
downside scenario would be a Fed forced into rate action due to inflation, even against a weaker growth picture. The upside would be an alleviation of the supply chain issues into a strong demand environment, resulting in growth with a reduced inflation picture and a less hawkish Fed. With Fed hikes on the horizon, we maintain our negative strategic bias.
December capped off a good year, as the S&P/LSTA Leveraged Loan index returned 0.64% for the month, bringing the full-year return to 5.20%. From a ratings perspective, lower quality outperformed higher-rated paper in December. Triple-Cs returned 1.08% for the month, as compared to B and BB returns
of 0.63% and 0.58%, respectively. Appetite for risk was in full effect during 2021 amid the broad economic recovery. Roughly $615 billion of new loans were sold in 2021, 22% above the previous high of $503 billion from 2017. The robust pace expanded the total size of the loan market to roughly $1.34 trillion, a new milestone for the asset class. Behind the strong appetite for new paper was robust demand from collateralized loan obligation (CLO) managers. Meanwhile, the loan market’s default rate remained unchanged at 0.29% by principal amount with no defaults experienced in December and only five in all of 2021.
Agency mortgage-backed securities (MBS) in December outperformed Treasuries due to the low market-volatility environment and rate sell-off in the long-end of the curve. In the near-term, the accelerated pace of tapering will be offset by the improving fundamental landscape. Although fed-funds rate hikes earlier on may lead to higher rate volatility, for the next three months the Fed is expected to make purchases of at least $60 billion of mortgages, which should keep financing rates/carry profiles attractive. Net new issuance in 2021 is expected to be roughly $850 billion, and the outlook for full-year 2022 volume is expected to be the second highest on record at approximately $650 billion. Total home purchase activity in 2022 may be similar to 2021, as an increase in conforming loan size and new home sales could be offset by a drop in existing home sales.
Our positive assessment proved warranted in December, and we’re carrying it with us into 2022 as the best array of credit conditions we have ever seen continues. While the inflation setup is tough, housing market dynamics, economic growth, and a well-positioned consumer all combine to make mortgage credit prospects look quite strong. Furthermore, with the expectation for rate hikes sooner the prepay outlook – which was a thorn in the residential mortgage market's side for much of 2021 – is set to improve. Affordability is a key risk to housing market dynamics, but it stops short of threatening strong mortgage credit behavior through the horizon and could perhaps prove a tailwind if it plays a role in moderating new issue supply from its current pace.
After some weakness in November and early December, conditions have seemingly firmed. Strains from a year of elevated issuance across single asset, single borrower (SASB) and commercial real estate (CRE), CLO markets were a root cause, which get a reset button of sorts with the new year. In addition, the sharp rally in corporate credit markets improves the relative value offered by commercial mortgage backed securities (CMBS) as well as market sentiment. Credit appetite is deep and perceptions of risk have shifted definitively lower, so we expect purchasing to happen at these wider levels.
After lagging the corporate credit rally into year-end, the asset backed securities (ABS) market appears set to better compete, at least thus far in 2022. New issuance is likely to be well received amid refreshed target allocations. In addition, any turn lower in broader market sentiment should allow ABS to shine. We maintain our assessment as positive and increase our conviction. The fiscally improved profile of the U.S. consumer coupled with ABS structural dynamics were already believed to provide the sector with a solid footing to withstand this sustained period of elevated, albeit improving, unemployment.
Emerging Market (EM) Debt
We continue to expect EM economic recovery to carry through into 2022, even if the pace of U.S. and European growth eases due to high input prices, supply chain constraints and potential Omicron variants’ administrative measures. That said, delayed re-openings, renewed travel restrictions and partial lockdowns may impact consumption and services related sectors, all while inflation is becoming more generalized as supply chain concerns impact input prices. We expect global capital flows to EMs will correlate with global financial conditions. The multi-speed and asynchronous EM growth rebound is expected to continue, with most countries struggling to close the output gap until late 2022. EM fiscal paths should remain the focus as consolidation has been delayed amid prolonged Covid-related supportive spending measures. Some Asian IG countries remain fiscally generous, even if restrictions ease slowly. In Latin America, further fiscal deterioration is possible with more populist candidates leading in several major election races.