Fixed Income Perspectives: Don’t Pop the Champagne for the Fed Just Yet

Keep an eye on wage growth. Recent inflation data has given investors positive signals, with U.S. consumer prices rising just 4.9% year over year in April, the smallest increase in two years. But we're holding off on the celebration. Inflation may persist for longer than the market anticipates, causing the Fed to keep rates elevated for an extended period.

If wages continue to increase or simply remain elevated, inflation will stay above the Fed’s target rate. Job vacancies are largely responsible for the continued strength in wage growth. A recent survey from the National Federation of Independent Business showed that 53% of small businesses reported “few or no qualified applicants for the positions they were trying to fill.” As long as this strong dynamic in labor markets persists, the Fed will likely hold rates steady. There is a scenario of a quick path to lower rates — but it’s not a path the market wants.

If the Fed pushes the fragile economy too hard, it could break. The Fed is navigating a maze in a fog; the economy seems mostly healthy, but leading indicators and looming uncertainties suggest we may be heading toward a more challenging period.

As we discussed last month, the senior loan officer survey implies a slowdown in bank lending, relieving some of the pressure on the Fed to tighten monetary policy but also increasing economic risks. If we are fortunate, the Fed can simply hold rates around 5% and let time do the work to cool the economy. However, if concerns around regional banks resurface on a broader scale, it could add to the economic strain, pushing the Fed to aggressively cut rates.

We have some grounds for celebration. In this environment of uncertainty, the silver lining for bond investors is that fixed income markets are offering attractive yields (Exhibit 1). Historically, yield has been a solid indicator of future bond market returns, and current levels suggest a potential strong run for fixed income.

Investment grade: While spreads remain stable, deteriorating fundamentals might leave investment grade companies vulnerable in a potential recession.

High yield: Decent earnings are keeping default expectations in check.

Senior loans: Increased macro sentiment influence and a potential rise in default rates due to high leverage call for a cautious approach.

Securitized credit: We continue to be cautious on CMBS, as the banking crisis is likely to accelerate deleveraging in commercial real estate.

Agency RMBS: Despite the risk of continued bank failures negatively affecting performance and demand, the market outlook for mortgages remains positive.

Emerging markets: China's reopening and supportive oil prices (due to production cuts) are creating a more favorable environment for EM debt.

Global rates and currencies

• Investors are focusing on actions and commentary from the FOMC and softening within the job market.
• Globally, shifts in central bank policies and the course of reflation or disinflation could cause significant shifts in global rates and currencies.

Investment grade corporates 

• Investment grade (IG) spreads remained stable in April, balancing out the uncertainty from bank failures against lower-than-anticipated supply and better-than-expected earnings.
• Overall fundamentals remain supportive, but the deterioration leaves IG companies less prepared for a potential recession, with further downward pressure anticipated as growth slows.
• Despite a tightening of spreads, there is still some room for near-term performance. However, we prefer to maintain liquidity for a more defensive stance if needed as valuations tighten.

Senior loans 

• First-quarter earnings for most public filers were better than anticipated, though expectations are lower for 2Q. Full implications will become clear once earnings for private issuers are released.
• Default rates are projected to rise closer to historical averages in 2023 as higher interest rates and increasing margin pressure start impacting highly leveraged balance sheets.
• We continue to trade out of weaker B rated names into higher-quality single-B’s, maintaining a low single-B risk profile and keeping close to index weight across all ratings cohorts. However, selling weaker B rated names has become increasingly challenging due to concerns around potential downgrades on poor fundamentals.

High yield corporates

• Lower quality outperformed in April due to the value of coupons in today's normalized rate environment, despite concerns about credit availability and stagnant equity markets.
• The fundamental landscape remains satisfactory, with generally decent earnings, positive ratings momentum, and subdued default expectations.
• The market is influenced by equity market volatility, causing market technicals to oscillate regularly. Valuations are reasonable in a slowing-growth environment, but risks are skewed to the downside.
• Within our portfolio, we are overweight in building products, retailers and chemicals (on a name-specific basis) and underweight in financials and telecoms. We maintain a mid-single-B risk profile.

Securitized credit

• CLOs: The outlook remains positive, as carry is substantial and market technicals are expected to stay favorable. However, concerns about default risks in underlying borrowers due to economic growth issues continue.
• CMBS: We remain negative on the sector due to an expected banking crisis–induced deleveraging process in commercial real estate (CRE). Tighter lending standards will likely increase defaults from less committed and capitalized borrowers.
• ABS: The outlook remains positive due to the sector's high quality, elevated yields, and reputation as a safe haven. Resilient collateral performance and a strong labor market support risk-taking. Consumer ABS offers a unique combination of fixed income attributes, but a more cautious strategic approach is warranted in sub sectors such as consumer loans and subprime auto due to potential underperformance risk.

Agency MBS 

• MBS performance is expected to improve with reduced Fed rate path uncertainty. However, this is being offset by the impact of bank failures and FDIC liquidations.
• Despite the risk of additional bank failures negatively affecting performance and demand, the market outlook for mortgages remains positive. This is due to the nearing end of the Fed's tightening campaign, wide spreads, suppressed organic supply, and potential for bank demand to return later in the year.
• Net supply (after accounting for Fed runoff) will likely come in at 2022 levels. However, if home prices continue to fall, supply may be limited further.

Emerging market debt

• The growth outlook for EM is muted for the full year, with mixed signals from PMIs and expected sequential declines YoY in most countries.
• Headline inflation has peaked in most EM countries, moving towards disinflation. However, EM companies face continued gross margin pressure due to government intervention limiting full pass-through of cost inflation.
• External factors continue to be the largest drivers of EM asset prices, with the U.S. growth outlook now the primary driver. Downside risks have increased due to recent banking stress. Despite these challenges, China's reopening momentum (particularly in the service sector) and supportive oil prices due to OPEC+ output cuts justify a positive outlook.