Has Fear Of The Fed Peaked?

By Brad Tank

As investors continue to digest the likely path of this tightening cycle, we think the dramatic moves of recent weeks are set to ease, laying a good foundation for credit investors.

Our latest Fixed Income Investment Outlook coincides with a dramatic period in rates and credit markets.

Last week saw the 10-year U.S. Treasury yield drive through the 2.7% threshold. The yield curve inverted—and then steepened again—at the closely watched two- and 10-year points. On Wednesday, the minutes from the Federal Reserve’s March meeting revealed new details of its plan for balance sheet reduction.

Meanwhile, credit spreads remain elevated and volatile as investors continue to assess the economic impact of tightening policy and the conflict in Ukraine.

How do we see these themes playing out over the next 12 months?

Peak Expectations

We now expect the Fed to hike rates by 50 basis points in both May and June, followed by a sequence of 25 basis point hikes until the policy rate approaches meaningfully restrictive territory. Given the strength, persistence and broadening of inflation, we think that terminal rate looks likely to be close to 3.5%.

This is in line with market expectations, which we think may be reaching a peak.

Our colleague Joseph Purtell has already outlined our key takeaways from the Fed’s March minutes. Here, we would highlight how soon the central bank plans to begin reducing its balance sheet, and how quickly it plans to proceed once it gets going. At a pace of perhaps $95 billion per month, it would be on track for a multitrillion-dollar reduction over the coming years.

We believe this is significant. Balance sheet reduction is not as effective a tool for fighting inflation as rate hikes, but it is important. So, when we think of the Fed combining those tools in pursuit of its price stability mandate, a faster pace with one may imply an easier pace with the other.

Inversion

That may be why market rate expectations declined slightly after the minutes came out—and why the yield curve re-steepened after briefly inverting.

Some analysts regard yield curve inversion as a signal of a coming recession. We generally don’t see it that way, and we are particularly skeptical on this occasion.

In our view, the relatively high two-year yield reflects the aggressiveness of the Fed’s proposed hiking cycle, while the long end of the curve remains depressed by quantitative easing, and by demand from institutional investors and overseas buyers of attractive hedged dollar yield. Moreover, the curve remains steep at points other than two and 10 years, and the real yield curve is also both steep and, at negative rates, quite stimulative.

With that in mind, market moves following the Fed minutes may reflect reassurance about the central bank’s ability to use both rate hikes and balance sheet reduction to bring prices back under control without inflicting excessive collateral damage on the economy.

Cushion

We think that fits with our view on economic fundamentals.

U.S. unemployment is almost back to pre-pandemic levels and the consumer remains in excellent shape. Household debt levels are close to record lows and savings remain high. This is also broad-based, with lower- and middle-income earners seeing particularly solid wage gains and wealth creation.

Overall, we think that makes for a considerable cushion to absorb both inflation and the policy-tightening necessary to curb it. We therefore anticipate slowing U.S. growth over the next 12 months, but not a recession. We see the risks growing on the two-year horizon, but remaining below our threshold for concern.

Foundation

Our Outlook sets out more detail on what we think that means for fixed income investment strategies, but these are the headlines.

With rate expectations peaking, we believe volatility in Treasury markets will begin to ease. We may see more curve steepening from here.

That, together with the robustness of the economy, provides a good foundation for credit, in our view. With both high yield and investment grade spreads pricing at near-recession levels, we see attractive value opportunities in a range of sectors.

Volatility is likely to remain elevated compared with 2021—we suspect the inflation data has yet to peak and could still generate some concern. But as investors continue to digest the likely path of this tightening cycle, we think the dramatic moves of recent weeks are set to ease.

In Case You Missed It

• ISM Non-Manufacturing Index: +1.8 to 58.3 in March
• China Composite Purchasing Managers’ Index: -6.2 to 43.9 in March
• Eurozone Producer Price Index: +1.1% in February month-over-month and 31.4% year-over-year

What to Watch For

• • Tuesday, April 12:
    • U.S. Consumer Price Index
  • Wednesday, April 13:
    • U.K. Consumer Price Index
    • U.S. Producer Price Index
  • Thursday, April 14:
    • European Central Bank Policy Meeting
    • U.S. Retail Sales

– Andrew White, Investment Strategy Group

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor’s individual objectives and circumstances and in consultation with his or her advisors. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. The firm, its employees and advisory accounts may hold positions of any companies discussed. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types.

This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosure-global-communications for the specific entities and jurisdictional limitations and restrictions.

The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.

© 2009-2022 Neuberger Berman Group LLC. All rights reserved.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.