With the Federal Reserve managing to raise interest rates without sparking a recession, the financial markets, the economy, and the Fed have found a “fragile equilibrium,” said Steve Boothe, T. Rowe Price’s head of global investment-grade debt.
“It’s a good time to be a bond investor,” he said at the mutual fund giant’s Global Market Outlook in New York recently. “We haven’t seen these kinds of yields in a decade. The excitement over fixed-income markets today is really going back to the core reason for why you should own bonds.”
Those reasons include getting paid a nice rate of interest in cash and a through line for capital appreciation.
After hitting a recent high yield of 5.5%, the 10-year U.S. Treasury bond is still elevated, ending the first trading day of the new year at 3.9%. The Treasury hit a recent low of 3.79% on Dec. 27.
The tenor of the fragile equilibrium shows a delicate sense of balance between the market’s bulls and bears. The bulls believe interest rates are peaking and inflation is coming down. The bears say labor inflation is sticky and that a recession is imminent. The bulls counter with the economy remains strong and manufacturing is set to accelerate. While the bears say the effects of the rate hikes have lagged, the yield curve remains inverted, and manufacturing reports are flashing recession. Finally, the bulls point out that there is still a lot of cash waiting to be invested, while the bears argue earnings expectations are too high.
“You can devise return streams, high-single-digit nominal returns without stretching beyond core investment-grade assets,” said Boothe. “But, there are a lot of short- and longer-term trends that appear to be hitting some kind of inflection point. A lot of these factors will introduce a degree of risk into the bond markets and other risk assets.”
The trends hitting inflection points:
· Peak Rates
· Peak Inflation
· Peak Liquidity
· Peak China
· Peak Housing
· Peak Fiscal
· Peak Credit
· Peak Employment
Boothe said the Fed’s halt in raising interest rates will bring some stability to the market.
In addition, T. Rowe’s Chief U.S. Economist Blerina Uruci believes that the Fed will keep interest rates higher for longer despite the financial market expecting rate cuts by the middle of the year. She said that because the economy, especially the labor market, remains resilient, that if the Fed were to pull back on monetary tightening too soon the economy could quickly fall back into a reacceleration of higher inflation.
She added the Fed will need to see signs of that the economy is approaching a recession before it will remove some of the monetary policy tightening that is in the pipeline.
Meanwhile, some of the issues and frictions in the bond market are the result of too much supply, said Boothe. Increased issuance of Treasury bonds caused a lot of bonds to hit the market at a time when the two major buyers — central banks and commercial banks — stepped away, creating a supply-demand imbalance that has resulted in a big spike in interest-rate volatility. However, that risk is peaking and bond supply should soon trend lower.
An interesting dynamic of this risk is attractive real yields. Following the stability/instability theme, this also introduces a material headwind into the larger economy.
Boothe added that an underappreciated dynamic is that the corporate bond market is reacting the opposite of the Treasury market. The issuance of investment-grade bonds has been down significantly on a year-over-year basis, which has contributed to a very stable environment.
However, for corporate America, which turned over their liabilities in 2020-21, the bill is coming. They will need to refinance their debt at interest rates 200 to 300 basis points higher, turning a source of stability into a source of fragility.
Boothe said T. Rowe’s forward-looking 12-month view of default rates is that they will rise to 3.5%, and this high default rate could last a while.
“The Fed will push off the idea of introducing rate cuts for as long as possible and prevent the market from pricing in cuts, despite meaningful progress on inflation,” said Boothe.
In addition, there is still stress in regional bank system as bank credit spreads have not retraced their widening in March. This could also extend the default cycle. Yet, over next 18 months, this historic spread between interest-rate volatility and credit volatility will compress, and credit volatility will move higher as interest-rate volatility moves lower.
With longer-date duration complicated due to a lot of risk at long end of the yield curve, Boothe concluded that shorter-dated higher-quality instruments look more attractive. “Keep it short and keep it high quality.”
Tim Murray, T. Rowe’s capital markets strategist, talked about asset allocation themes and said the economy was in a purgatory state, where it looks like the economy avoided a recession, but won’t experience a full recovery until the Fed cuts interest rates.
His big theme was “Don’t be a Hero” because resolution isn’t coming soon. He said seek out asset classes and entry points where and when a recessionary scenario is priced in, but be prepared to wait for it to pay off. Murray added that portfolios need “to account for both inflation risks and recession risks.”
Meanwhile, the stock market’s performance has been top heavy as valuations have been distorted by mega-cap technology stocks, specifically the Magnificent 7: Apple
AAPL
, Alphabet (GOOG), Amazon.com (AMZN), Meta Platforms
FB
– formerly Facebook (META), Microsoft
MSFT
, Nvidia (NVDA), and Tesla
TSLA
.
Murray added that most fixed-income asset classes offer attractive yields and investors should pursue yield while waiting for this purgatory to end.
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