Navigating the Fed narrative will become an integral part of the path of interest rates as the Fed shifts to the “pause” cycle. Conflicting data is one reason for the persistent debate over when the shift in monetary policy will occur. Leading indicators such as the purchasing managers’ index and ISM sentiment, along with the yield curve inversion, point to a recession, while lagging indicators led by labor and inflation data do not. As the laggards catch up with the leaders, market prices should shift. This coincides with our expectation of a decline in 10-year yields over the coming year. While the labor market has not yet rolled over, it is clearly slowing, with nonfarm payrolls now 200,000 from an average above 440,000 in the first half of 2022 and 560,000 in 2021. While US consumer balance sheets remain healthy compared to other pre-recession period—with higher levels of savings than before the pandemic—inflation has eroded those savings, and “excess” savings are starting to fall.
We expect 10-year yields to decline to around 3.5% in the first half of 2023. The heightened level of volatility witnessed in 2022 may be behind us, but volatility will remain a source of vulnerability to fixed income markets this year. The forward curve points to a slight variation within the 10-year yield, and although the inversion of the yield curve is a contributor, it will not be as smooth as it may appear. Inflation remains the largest concern for the Fed, so we cannot dismiss the possibility that the terminal fed funds rate will exceed 5%. The probability of a recession now exceeds 50%, which helps to explain why the 1-year CPI swap is currently priced at a mere 2.35% and the forward market is already pricing in an easing at the end of 2023. The Fed narrative is key, and what we have heard so far is that increasing the fed funds rate at the risk of growth is not necessarily a policy error for the Fed, but a policy trade-off as inflation remains the focal point.
However, as the market recognizes the lagging impact of monetary policy to the real economy, we think US GDP will grow below trend over the next year as housing activity continues to slow, business surveys continue to trend downward, and bank lending continues to contract. A risk to our view of a downward trend in yields would be China’s reopening forcing commodity prices and GDP growth higher, and the US labor market and wage growth remaining resilient even in the face of higher prices and financing costs.
Yield of dreams
CIO has incrementally increased its interest rate risk exposure throughout its fixed income portfolio. Moving senior loans to least preferred in mid-2022 in favor of the short-end and intermediate IG and agency MBS has added interest rate risk. As we have discussed, we would not recommend moving past the intermediate part of the yield curve until we see the 10-year Treasury yield once again reach near 4%, which we believe will occur in the first quarter.
It is not our view that the 10-year yield will pierce the 2022 high of 4.25%; however, if our expectation proves incorrect, the yield earned on fixed income spread product will provide ample downside protection.
We show the current yield and spread alongside their 10-year averages for various fixed income sectors. Bond investors can earn yields well above the 10-year average, but caution is warranted among weaker credits as the amount of risk premium offered to investors for lower-quality credit is far from ample. For sectors such as high yield (HY), the current spread, 450bps, is around the 10-year average, and although we acknowledge the convexity implicit at a lower dollar price of 85, tighter financial conditions and bank lending standards have yet to fully flow through to HY spreads. Technical factors, such as supply have remained a performance tailwind, with new-issue supply down 78% in 2022, the lowest since 2008. As interest rates fall in 2023, we anticipate supply will rise along with the default rate as the economy contracts.
Fortunately, given the wider opportunity set within fixed income heading into 2023, a more defensive posture does not equate to low yields. Though we think interest rates could initially rise in the first quarter, we continue to prefer the short-end investment grade (IG) sector over floating-rate senior loans. The floating-rate nature may appear to represent a tailwind to rising rates, but it is our view that widening spreads will counter the lower interest rate risk, as demand continues to wane in both loans and lower-quality CLOs.
Short-end IG offers yields over 300bps above their 10-year average, thanks to the inversion of the yield curve, while maintaining their higher credit quality. We aim to protect against the potential rise in rates with short-end ladders and would move from 1–3-year to 1–5-year during 1Q23.
As 2023 begins, we believe fixed income will regain favor among investors as bonds reclaim their traditional role as a portfolio diversifier. At current yield levels, we believe the liquidity-driven phase of the 2022 market meltdown is over, and the market will now focus on the fundamentals. We remain tactically long interest rate risk in our fixed income portfolio, but we are not over-extended as we believe volatility will persist in the near term. The short and intermediate 7-year is our preference for positioning, and we look to add interest rate risk through higher-quality sectors as opportunities arise.
Main contributor: Leslie Falconio
Read the full report Fixed Income Strategist: Navigating the narrative 10 January 2023.
This content is a product of the UBS Chief Investment Office.