The Road to March

The Road to March

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Matt Toms

Matt Toms, CFA

Chief Investment Officer, Fixed Income

The market’s expectations for curve flattening may be excessive, as the timing of rate hikes and the aggressiveness of the Federal Reserve are still open to debate.

Less than two months into the new year, global central bank policy has turned more hawkish. The Bank of England hiked rates 25 basis points (bps) in early February, while the European Central Bank announced it would become data dependent as inflation and wage pressures have started to percolate further, leading to expectations that its first interest rate hike could come during the second half of 2022.  The most dramatic shift, however, has come from the U.S., with the market now pricing in six interest rate hikes for the year and about a 50% chance of a 50bp hike in March. What is notable is that much of the shift has come from the market, rather than from the Fed itself. Outside of Fed Governor Bullard, most participants, including Fed Chair Powell, have shied away from a more aggressive pace of rate hikes as evidenced by the January FOMC meeting minutes.

We continue to believe that the Fed will be measured with its pace of rate hikes. Market expectations have been pulled forward significantly, with some even calling for up to seven hikes for the year. This has largely been driven by the latest strong jobs report and a hotter-than-expected January inflation print, which showed a wider dispersion of inflationary pressures outside of housing and vehicles. As such, the Treasury curve has flattened significantly, driven by the move higher in the 2-year yield. And although the longer end of the yield curve has also moved higher – notably the 10-year yield – there has been some consolidation around 2%. This is likely due to concerns that an aggressive move by the Fed could have potentially negative economic consequences. Long-term bond markets are also reminding investors that the disinflationary factors that suppressed inflation for the last 15 years – technology, robotics, excess savings, worsening demographics – are still present.

Even as the market is focused keenly on upside inflation risks, we believe inflation will begin to moderate in the first half of the year. As a result, the Fed will likely be raising interest rates into a falling inflationary environment, leading to a shift in the narrative from the Fed falling behind to whether the Fed is catching up quickly enough. This could result in a suppression of both growth and inflation expectations, echoing the pre-pandemic environment of low growth and inflation. The key to sustained growth, in our view, will be a handoff from accommodative fiscal and monetary policies to a period of increased capex and investment from the private sector. We are seeing signs that this is beginning to happen: higher wages and input costs have led to increased incentives for companies to invest in labor alternatives.

With corporate credit spreads looking more attractive, we are looking for opportunities to rotate some exposure from securitized credit to investment grade and high yield. However, we believe volatility will continue until there is more clarity around the Fed’s path, which should come at the March Fed meeting. Until then, we remain selective on adding risk in the near term despite cheaper valuations.

Bond Market Outlook

Global Rates: Yields edged higher driven by ongoing inflation worries and 2022 rate-hike expectations

Global Currencies: U.S. dollar to remain rangebound as market balances global COVID concerns, hawkish central bank policies

Investment Grade: Fundamentals solid and valuations more attractive but spreads could widen further in near term

High Yield: Spreads look cheap but could move wider, BBs beginning to show reasonable entry point

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 unsynchronous amid supply chain uncertainties and rebound in trade

Rates, Spreads and Yields
Rates, Spreads and Yields

As of 01/31/22. Source: Bloomberg, Bloomberg/Barclays, JPMorgan and Voya. Past performance is no guarantee of future results.

Sector Outlooks

Global Rates and Currencies

Many developed market central banks continue to express a hawkish stance as they contemplate how to balance the prevailing inflationary environment with a desire to normalize monetary policy. As such, the dollar appreciated against all G10 currencies in January, partially driven by Fed policy. During the Federal Open Market Committee’s press conference, U.S. Federal Reserve Chair Jerome Powell conveyed a stronger focus from the committee on containing inflation, while also emphasizing the tightness of the labor market. In the coming months and quarters, trends in wage growth, shelter, and supply dynamics will influence the trajectory of trajectory, as will labor force participation and consumer spending. In the meantime, U.S. Treasury yield curve flattening has manifested across the curve, with markets now pricing in up to five Federal Funds Overnight Interest Rate hikes in 2022.

Investment Grade (IG) Corporates

Investment Grade spreads widened 14 bp in January, the biggest sell off since March 2020, as the market began to price in a more aggressive Fed rate-hiking cycle. New debt sales were heavy and dealers reduced their balance sheets given the risk-off tone, which only further fueled to the sell-off in corporate credit. We think it makes sense for IG spreads to find a new equilibrium level given higher volatility, and we don't expect spreads to ease back to 2021 levels. Despite higher volatility, the fundamental picture looks solid, supporting our view that credit will be fine once the market prices in likely Fed action. Spreads look more attractive than they have in a while, but we do think they can go wider in this environment. As such, we remain selective in adding risk among spread widening. We continue to see the most value in seven- to ten-year bonds with the long-end of the Treasury curve flattening. Sector wise, we continue to like financials, telecommunications, utilities, and technology.  

High Yield Corporates

High Yield got off to a rocky start to 2022, as the market followed suit with other risk assets and repriced downward. Early pressure on BB-rated issues reversed a December rally that was a bit overdone, in our view. As the month went on outflows picked up, sentiment deteriorated, and selling across the ratings spectrum ensued. Technical dynamics were decent coming in but deteriorated steadily, perhaps reaching a bottom toward monthend. However, fundamentals remain solid, though we do expect pressure to remain. Given the magnitude of the of the sell-off, valuations are now looking much improved. 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. 

Bank Loans

Broad-based volatility emerged across financial markets, resulting in a rocky start to the new year. Among a litany of concerns, investors digested a more hawkish posture from the Fed, a meaningful spike in global government bond yields, and increasing geopolitical tension between Russia and Ukraine. Spreads widened in both investment grade and high yield bond markets, while tech stocks led a notable drawdown in equities. Despite these developments, the S&P/LSTA Leveraged Loan index returned 0.36% to start the year, far better than the negative returns experienced in other markets. Secondary levels generally held steady, although softened towards the end of the month. In general, the outperformance of riskier segments was a function of their higher carry with market value movements largely limited across all categories. New-issue activity started the year off on a strong note, as deals backing M&A’s and LBO’s underpinned roughly $72.2 billion of supply, the second highest January volume on record. Furthermore, 98% of January’s total loan issuance was tied to SOFR, as the market moves away from the use of LIBOR as the primary base rate for coupon calculations.

Securitized Assets

Agency mortgage-backed securities (MBS) in January underperformed U.S. Treasuries as mortgage-extension risk became more relevant in a sell-off interest rate environment. Among issuers, overseas accounts, and bids from collateralized mortgage obligation (CMO) creation supported GNMAs despite buyout risk. Conventional mortgages underperformed due to underwhelming bank demand and reduced Fed purchases. Net issuance in 2021 was $875 billion and the outlook for full-year 2022 is expected to be the second highest on record at around $650 billion. Total home purchase activity this year 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. In the near-term, the accelerated pace of tapering will be offset by the improving fundamental landscape. Although faster rate-hikes may lead to higher rate volatility, the Fed is expected for the next three months to net purchase at least $60 billion of mortgages, which will keep financing rates and carry profiles attractive.

After a reasonably good fourth quarter of 2021 and strong start to January, the final week of the month turned quickly and definitively against non-agency residential mortgage-backed securities. We have downgraded our assessment on the view that this is likely to continue into February but stabilize reasonably quickly. Therefore, we are neutral on the sector, despite an array of positive credit conditions. Housing markets remain in expansion mode and mortgage credit performance will continue to be influenced positively by this and the burgeoning credit availability from government sponsored entities. Other supportive supporting dynamics include improving unemployment, more room for home ownership growth, and the Millennial demographic’s continued progression into ownership.

Commercial mortgage backed securities (CMBS) performed well in January after a weak ending to the fourth quarter of 2021. However, strains from elevated issuance across single asset, single borrower (SASB) and commercial real estate (CRE) collateralized loan obligation (CLO) markets caused stress toward month end. This weakness – which was enabled by supply - is likely to continue as the nearterm pipeline remains full and sponsorship is less robust. We therefore reassess our tactical outlook as negative. In addition, the sell-off in corporate credit markets weakened (but did not extinguish) the relative value offered by CMBS. Credit remains appetite deep and perceptions of risk have shifted definitively lower, so we expect purchasing to happen at these wider levels.

We have since downgraded our assessment for ABS following a strong start 2022. After initially being well received and catalyzing spread tightening, issuance is now likely to be less well received and struggle to improve upon the spread tightening in January. After the pronounced bear flattening from December to January, improved yield profiles are likely to attract more interest from income-focused buyers. Therefore, widening potential is limited. However, a weakened relative value proposition after a divergent move in corporate credit could drive underperformance into a potentially more stable macro backdrop. Furthermore, we continue to expect benchmark asset types that are more closely tied to the Fed's quantitative easing and related tapering to experience weaker sponsorship, as the buyer base shifts from banks back to money managers.

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 lower fiscal impulse, high input prices, supply chain constraints and potential Omicron variants’ administrative measures. EM growth rates have returned to pre-pandemic levels on average, but the outlook is differentiated. Asia is expected to exceed pre-pandemic levels for the fourth quarter of 2022, but CEEMA is expected remain range-bound while Latin America is expected to lag. We expect global capital flows to EMs will correlate with global financial conditions. EM fiscal paths to 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 races.

Past performance does not guarantee future results.

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the visibility of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.

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