The market had pushed forward an aggressive rate path for the Federal Reserve—initially leading to a 3.5% terminal rate by the end of 1Q23, pushing US 2-year and 10-year yields higher by 180 to 200 basis points—while credit spreads remained well contained (albeit wider) particularly given the correction within the equity market. As a result, interest rate risk has been the dominant driver of negative total returns.
We maintained the view that both market expectations regarding the path of the federal funds rate and the velocity of the rate rise would eventually correct. We anticipated that the 2018 high in 10-year yield of 3.26% would remain the peak for 2022, particularly given the hawkish outlook priced in, including the Fed’s quantitative tightening which is set to begin next month. We became more cautious toward those sectors that initially outperformed their historical correlation to either the equity market or the rise in WTI oil prices such as high yield and senior loans.
The shift in sentiment
The impact of tightening financial conditions has spilled over the US rates market as the 10-year yield has contracted around 50bps since the 6 May high, making equity returns and Treasury yields once again negatively correlated. Following a handful of macroeconomic disappointments such as the 1Q GDP data and the fastest increase in US mortgage rates in decades, which indicated a headwind to housing, several rate hikes have been removed from the market’s 2023 rate projection, which is now at 2.88% versus the near 3.5% earlier in the month.
Signs of slowing supply chain bottlenecks, combined with a poor 10-year TIPS auction, have led to the largest monthly drop in 10-year breakeven inflation expectations since 2020. The belief that peak inflation may be behind us is now being priced into the forward inflation curves, as both forward inflation swaps and breakeven inflation expectations have collapsed to 2.6% and 2.2%, respectively.
The credit catch-up
Though we anticipated credit spreads to widen after months of staying range-bound, the widening has occurred at an alarming rate. While new high yield bond supply is running at just 24% of last year’s pace, and investors are earning yields near 8%, investors remain sidelined. Lower quality CCC has returned a –6.4% month-to-date, the worst monthly loss since March 2020, as the HY index nears 500bps in spread, the widest since November 2020. But this spread remains lower than previous equity market corrections of 15% or more, potentially due to higher oil prices. We remain cautious on high yield spreads and look for more widening heading into the June FOMC meeting. With lower fed funds projection, lower inflation expectations, and widening credit spreads, the market now sees the US 10-year yield ending the year at 2.88%—near CIO’s 2.7% expectation.
Main contributor: Leslie Falconio, Head of Taxable Fixed Income Strategy
Content is a product of the Chief Investment Office (CIO).
Original blog – US fixed income: From head to tail, 25 May, 2022.
Tags: #fixed #income #tail