Higher Yields A Global Phenomenon
September 2022
The U.S. Treasury yield curve shifted higher during August, driven by forces at home and abroad. Stateside, FOMC members were out in full force early in the month, making a coordinated effort to push back on a potential dovish pivot, a narrative that made the rounds in the wake of the Committee’s late-July meeting. Bond investors initially doubted the FOMC’s inflation fighting resolve but were forced to buy in after FOMC Chair Jerome Powell’s decidedly hawkish, pointed, and carefully worded speech at the Fed’s Jackson Hole symposium on August 26. The 2-year Treasury yield jumped 56 basis points during the month to close at 3.45% while the 10-year yield rose 48 basis points to 3.15%, leaving the yield curve still inverted as the market took the FOMC at its word that it would inflict economic pain and accept a recession to curb demand and tamp down inflationary pressures.
Post-Jackson Hole Fed funds futures shifted from a coin-flip between 50 and 75 to pricing in a 70% chance of a 75-basis point hike in September. With balance sheet runoff ramping up from $47.5B per month to $95B this month, some Committee members could push for a more measured half-point hike, but our base case calls for another 75-basis point hike mid- month. Volatility in the rates market is likely to persist as market participants adjust to the Fed running down its balance sheet in a more aggressive manner, which, when combined with slowing economic growth, should lead to higher yields/wider credit spreads for most segments of the fixed income market over coming quarters.
Warm weather generated greater demand for electricity in the Eurozone in August, leading to a price spike as fears of natural gas shortages into the winter months grew. Higher energy and electricity prices put upward pressure on Eurozone inflation and euro area sovereign bond yields, and business closures, layoffs, and loan defaults are likely to follow. Coming quarters will pose a challenge to the EU’s united front related to Russian sanctions as the gulf between the haves and the have nots at the country level within the euro area widens. Upward pressure on euro area sovereign yields is likely to persist as the European Central Bank (ECB) tightens monetary policy, potentially much more aggressively due to high inflation, as recession/stagflation fears remain and concerns surrounding a sovereign debt crisis build.
Issuance of corporate bonds often picks up in September as CFOs try to front-run potentially sluggish demand in the 4th quarter of the year. Supply of high yield corporate bonds could accelerate in a big way this month as high yield issuance year-to-date through July came in at just $80.6B, well short of the $328.3B issued in the first six months of 2021. We remain neutral on high yield bonds as we expect defaults to remain relatively low into ’23. Security selection will be of paramount importance, benefitting active managers relative to index-linked exposures as credit spreads should widen as global economic growth slows and monetary policy tightens, reducing liquidity and risk appetite.
We maintain an underweight to international fixed income but maintain an exposure to U.S. dollar denominated emerging market debt as we see significant opportunity in the asset class over the intermediate term, despite facing near-term pressures from a stronger U.S. dollar, elevated commodity prices, and a global economic slowdown. We recommend a portfolio duration in-line with that of the Bloomberg Aggregate Bond index and favor U.S. Treasuries and short duration investment-grade corporate bonds as we expect volatility in the rates market to be with us for quarters to come.
Source: SIFMA
