Higher Rates Reinforce Income’s Appeal

Transcript

The Federal Reserve and European Central Bank are set to raise rates again this week to fight inflation.

But markets are pricing rate cuts in 2023 even as both central banks insist that they will stay the course.

1) Policy rates higher for longer

We see the disconnect resolving in favor of central banks.

Inflation is set to fall a lot – but not all the way to 2%, in our view.

Like central banks, we are looking for wage pressures to sustainably subside. They’ll want to see this before declaring victory on inflation – so rate cuts are a long way off.

2) Risks underpinning higher long-term yields

That’s one reason we prefer short-term bonds. Another is that we see investors demanding more to hold long-term bonds.

That might happen if the Bank of Japan changes its yield curve control policy and that causes market dislocations.

That may also happen amid the tussle to lift the U.S. debt ceiling, though we do expect negotiations to be resolved.

3) Opportunity in short-term fixed income

Short-term government bonds and investment grade credit now offer some of the highest yields in the last two decades.

We prefer them for income. We also like agency mortgage-backed securities to diversify income.

Global investment grade credit offers even more yield than short-term bonds, and should weather a downturn.

We like short-term government bonds and high-grade credit for their income potential.

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Major central banks are set to hike policy rates again this week and keep them higher, counter to market views for cuts this year. We see this disconnect resolving and favoring higher rates. That’s because we think inflation will fall fast but stay above target. Rates staying high plus the political tussle over raising the U.S. borrowing limit are market risks. We prefer to earn income and like short-term government bonds, high-grade credit and mortgage-backed securities.

Yield is back

Notes: The chart shows yields for the Bloomberg Global Aggregate Corporate Index and benchmark two-year U.S. Treasuries.

Income is finally back in fixed income, thanks to higher yields and coupons. Short-term government bonds and investment grade (IG) credit now offer some of the highest yields in the last two decades. See the chart. We prefer to earn income right now from these high-quality fixed-income assets as rates rise and stay high. Fixed income’s appeal remains intact the longer central banks keep rates near their peak. The lack of duration – or the sensitivity of bond prices to interest rates – in short-term paper also helps preserve income even if yields rise anew. Global IG credit offers high-grade, liquid income – and we think the strong balance sheets of high-quality companies that refinanced debt at lower rates can weather the mild recession we see ahead. We also like agency mortgage-backed securities (MBS) to diversify income.

We see major central banks on a path to overtighten policy because they’re worried about the persistence of underlying core inflation, excluding food and energy prices. PCE data in the U.S. confirmed the outlook for core inflation hasn’t improved, and it’s tracking to be well above policy targets into 2024. Core services inflation is proving sticky even as goods prices fall. That stickiness is tied to wage pressures in the labor market that we see remaining tight. We think central banks will want more evidence that core inflation and wage pressures are sustainably subsiding before they declare victory on inflation and think about easing policy. This will take a long time – and is unlikely to happen this year, in our view.

This week, the Fed and ECB are set to push rates further up again. We see the Fed hiking 0.25% and the ECB raising 0.5%, with more hikes likely to follow. Then we see them keeping rates high. But markets are pricing rate cuts in 2023 even as both central banks insist they will stay the course. That disconnect needs to be resolved, and we think it will be in favor of higher rates as inflation persists above central banks’ 2% target. Rates staying high is one reason we prefer earning income with shorter-duration paper.

Term premium’s return

Another reason is term premium – the compensation investors demand for holding long-term government bonds. We see investors seeking more term premium with higher inflation and other near-term risks on the horizon. Political pressure on the Bank of Japan to change its yield curve control policy is likely to ramp up with inflation running at a four-decade high. The risk: a global spillover from higher Japanese government bond yields to global yields. We think moving away from yield curve control would be like a move away from a currency peg – even tweaks could lead to abrupt market dislocations.

Risks over raising the U.S. borrowing cap are also in focus now after the U.S. hit its debt ceiling this month – this reinforces our view that investors will once again demand term premium. Negotiations are likely to go down to the wire this summer and could be as fraught as 2011, when S&P Global downgraded the U.S. triple-A credit rating. We ultimately expect a resolution. If a U.S. default were to occur, it would likely be technical in nature, meaning the U.S. would prioritize debt payments over other obligations. We would expect only a temporary rise in selected Treasury bill yields as the default date nears. Another debt ceiling impasse could also pressure risk assets as in past episodes – this keeps us cautious on U.S. equities.

Our bottom line

Rates staying high and the political tussle over the U.S. debt ceiling are market risks. We take a granular view on fixed income at this juncture. We tactically like short-term government bonds, high-grade credit and agency mortgage-backed securities for attractive income.

Market backdrop

U.S. stocks climbed and bond yields were mostly steady, with European and emerging market shares outperforming the U.S. on investor inflows. U.S. GDP was resilient in the last quarter of 2022. Consumer spending helped prop up growth, but we see signs of weakness beneath the surface. The U.S. PCE data showed consumer spending was losing momentum at the end of the year and suggests that growth is slowing more quickly than we expected.

The Fed and the European Central Bank anchor this week’s central bank decisions. We see them both pushing up rates further and pushing back against market expectations for rate cuts. The U.S. services PMI and payrolls data will give the latest view on recession risks. We think further resilience in activity and the labor market could embolden the Fed.