March: A Seismic Shift In Expectations
March 2023
Sovereign bond yields across the globe - with Japan a notable outlier - were making year-to-date highs as February concluded. In Europe, yields on 10-year U.K. gilts approached 3.85%, a level last seen in October of 2022 amid a panic by pension funds to sell long-dated bonds as buyers dried up. Yields on 10-year German bunds rose to 2.70% a level last seen in 2011 as hotter than expected February inflation data out of France, Germany, and Spain led to calls for the European Central Bank (ECB) to hike key interest rates by a more aggressive half-point when it met in March. The ECB ultimately followed through with a 50-basis point hike to combat still elevated inflation but did not issue forward guidance as it sought to leave its options open. U.S. Treasury yields rose alongside sovereign yields in the U.K. and euro area as January inflation data stateside also came in hotter than expected, leading Fed funds futures to price in a higher terminal Fed funds rate and push out interest rate cuts from late 2023 into 2024. However, a resilient labor market and inflation stickiness took a backseat to the health of the U.S. financial system in early March, leading to a seismic shift in expectations for the path forward for monetary policy.
Silicon Valley Bank, known as SVB, formerly a top-20 U.S. bank by assets, experienced sizable deposit outflows over just a few days’ time from venture capital (VC)-backed early-stage companies, a group that made up the lion’s share of its customer and deposit base. To meet deposit withdrawals, the bank was forced to sell holdings of Treasury and mortgage-backed securities (MBS) at prices below where they were carrying them on their balance sheet, which led to capital shortfall concerns. After the bank was unable to raise equity capital, it tried to sell itself, a move that also failed and the bank fell into FDIC receivership. In the wake of the failure of SVB and Signature Bank of New York also entering FDIC receivership, questions arose as to whether the liquidity issues troubling these two specific institutions were emblematic of what the broader banking industry was experiencing. Given what we know of SVB and Signature’s customer and geographic concentrations, we believe these to be firm-specific issues and not indicative of a broader issue plaguing the banking space.
With that said, the FOMC now finds itself in an even more precarious situation when it meets in March as hiking the Fed funds rate by a half-point would increase the risk of an even more abrupt economic slowdown as money supply is already likely to contract as banks tighten lending standards and raise deposit rates in response to SVB’s downfall. On the other side of the coin, failing to hike at all given recent inflation and labor market data could lead to upward pressure on yields across the Treasury curve as inflation expectations become entrenched and even more difficult to reverse. We believe the demise of SVB and Signature Bank has removed any chance of a half-point hike to the Fed funds rate this month and view a 25-basis point hike as our base-case as the stability of the banking system outweighs a string of hotter inflation and labor market readings. As a byproduct of this view, an active, duration neutral fixed income portfolio remains warranted as we expect interest rate volatility to persist.
Shorter Duration, Higher Quality Corporates Hold Appeal. The upward lift in global sovereign yields throughout February pressured longer duration bonds while leaving lower quality pockets of the fixed income market less negatively impacted. Case in point, while the investment-grade (IG) Bloomberg Corporate index fell 3.2% during the month, the Bloomberg U.S. High Yield (HY) index fared far better, giving back just 1.3% due to the shorter duration profile of the index. However, March has been far more kind to ‘quality’ as Treasury yields have moved lower amid risk-off amid SVB’s liquidity concerns, and if lending standards tighten and the likelihood of a recession rises, we would rather be in higher quality investment-grade corporates relative to high yield corporates with a similar duration profile.
A Policy Shift In The Offing For The BoJ. The Bank of Japan (BoJ) has maintained an easy money bias primarily via its yield curve control program. Yield curve control is a commitment from the BoJ to buy Japanese Government Bonds (JGBs) should yields rise to an undesirably high level, currently 0.50% on the 10-year JGB. The BoJ’s approach has been under fire due to the heavy costs incurred from continuing the program as the central bank has been forced to sell U.S. Treasury holdings to maintain the current peg. Central bank watchers have been sounding the alarm that the BoJ’s yield curve control program was unsustainable for months, and with current Governor Kuroda’s term ending in April, a policy shift is more likely once his successor takes the helm, leading us to expect movement in the April/May timeframe, contributing to interest rate volatility in sovereign bonds in the interim.
As of March 17, 2023
