Since the beginning of the year, 10-year US Treasury yields have fallen by nearly 50 basis points and volatility has collapsed to levels not seen since June 2022. Falling inter est rates, combined with declining volatility, represent a tailwind for what is referred to as the “carry trade,” an allocation often toward lower-quality sectors with the expectation that yield, or carry, will be the driver of total return in a lower-volatility environment. When we overlay the reality that the Federal Reserve is near the end of its historically hawkish policy stance, the cautionary stance among investors in 2022 has pivoted to a fear of missing out, alongside some short position covering.
The market continues to price in a “Goldilocks” outcome by discounting the probability that the Fed will reach its stated terminal federal funds rate and hold it higher for longer. Despite the addition of over half a million jobs in January, along with a decline in the unemployment rate to 3.4%, market participants continue to price in a terminal rate below 5% and a high probability of a rate cut of 30-50bps in the second half of 2023. Although the lag between FOMC action and its impact on the economy means the effects of past rate hikes will continue to be felt this year, the market has pushed forward these potential economic impacts and shifted to a speedy conclusion to tight monetary policy, pricing in a total of 180bps of easing through 2024.
Count us among the skeptical. The Federal Open Market Committee did reduce the pace of Fed hikes to 25bps at its last meeting, but the accompanying statement clearly signaled that further rate hikes are expected. We continue to believe that two 25bps rate hikes-one in March and an other in May-are highly likely. This will put the federal funds rate between 5% and 5.25%, or around 5.1 %, near where the Fed has guided. Although economic data will lead the way, whether a rate-hike pause turns into a pivot or is followed by additional hikes will depend on the balance between inflation and recession risks. But a quick policy reversal to an easier monetary policy in 2023 appears unlikely.
Ripping, not tipping
Financial conditions have loosened to levels not seen since late August, or, put another way, 225bps of rate hikes ago. We were a bit surprised not to see Fed Chair Jerome Powell push back on this easing of financial conditions as the VIX dropped below 18 and the MOVE index collapsed, resulting in year-to-date returns of over 8% and nearly 6% in the high yield (HY) index before the nonfarm payroll report was released. We see a high probability that this current lack of concern over loosening financial conditions will soon shift even in the face of positive real yields and higher borrowing costs, both of which are restrictive to the economy.
The pull forward of performance ignores the potential for slower growth conditions ahead. We do not believe that the Fed pause expected around May will result in a policy pivot this year, as uncertainty regarding sticky inflation will remain in focus. We do expect growth to continue to slow, and while we are not looking for a reversal of Fed policy in 2023, we acknowledge that higher rates make the operating environment more difficult for companies-and economic and financial stress often follows.
Given the rip tighter in spreads for both higher-quality and lower-quality assets, the opportunity set that was abundant in fixed income markets when we started the year a mere six weeks ago-has abruptly narrowed. HY spreads reached 395bps while investment grade (IG) spreads reached 120bps after the nonfarm payroll report the lowest spread levels since April. In other words, spreads are back to levels witnessed when the Fed had just started raising inter est rates by a mere 25bps and had not yet started its official quantitative tightening program.
Technical tailwinds have been a contributing factor to tightening spreads, particularly in the higher-quality sectors such as IG corporates. Over USD 10 billion of net inflows have been allocated to bond funds. How ever, as HY risk premiums continue to com press, the inflows and outflows in HY fund shave been mixed, with year-to-date net flows of roughly USD 850 million.
Read the full report Fixed Income Strategist: Pulling forward to push back 9 February 2023.
Main contributor: Leslie Falconio
This content is a product of the UBS Chief Investment Office.