The global sovereign debt markets have arguably experienced their worst year on record. However, an interesting development has occurred in the process; the era of negative rates has seemingly drawn to a close. With the exception of Japan, government bond markets in the developed world have now seen yield levels move into positive territory for the key 2-, 5- and 10-year maturity sectors.
Source: Bloomberg, as of 1/1/2017 through 11/28/2022.
This development has created an interesting phenomenon: there’s “income back in fixed income.” The recent rise in U.S. Treasury (UST) rates has brought yields to levels not seen since 2007–2008, or a period spanning roughly 15 years. In other words, there is a whole generation of investors who have never experienced UST yields at these elevated levels.
Source: Bloomberg, as of 1/1/2007 through 11/28/2022.
The natural question becomes: is there more to come? In other words, can UST yields continue rising from here? Let’s put the answer in the context of future Fed policy. If the aforementioned expectation for a 5% Fed Funds terminal rate does come to fruition, Treasury yields will more than likely continue to rise, especially along the front end of the curve, as yields need to adjust to this potential higher Fed Funds Rate.
For investors, these higher Treasury yields, both currently and potentially even higher in 2023, are creating a scenario in fixed income that investors have not been presented with in one-and-a-half decades. As a result, opportunity could be knocking on the door for bond investors in 2023.
While our base case is for the Fed to continue to raise rates in the first half of 2023, around the end of second quarter, we expect the Fed to pause which could lead to a modest rally in rates along with a steeper curve. Rate volatility will remain elevated; however, we believe we will not experience the rise that we witnessed this year.
As discussed, income is back in Fixed Income. We favor corporate issuers combining strong fundamentals and resilient balance sheets with debt seeking to offer attractive income. Selectivity remains key for investors, as the slowing in the economy will create a differentiated set of opportunities.
We also believe with the rise in rates and mortgage borrowing rates, opportunities will develop to increase exposure in mortgage-backed securities sometime this year. Wide mortgage spreads and positive convexity, a phenomenon that hasn’t been seen in a while in agency MBS, hint at potential value, but the lack of potential institutional buyers and the threat of MBS sales from the Fed’s balance sheet remain risks to this view.
The outlook for emerging market debt hinges on the magnitude of any global recession that emerges. If the landing is soft, valuations in currencies, local debt, and USD corporates provide attractive opportunities. But movement towards a hard landing provides a more substantial headwind.
THE DOLLAR
The rapid pace of Fed tightening this year injected carry back into USD-assets (particularly relative to other Developed Market assets). Bonds suffered near-term pain in the transition to higher rates, but the US Dollar rode the Fed rate hikes to one of best years in recent memory. Unfortunately, it has also pushed the Dollar, which started 2022 as expensive to extreme valuation levels.
Carry will likely continue to be supportive, but it is unlikely to the driver that it was for 2022. The Fed is on pace to continue raising rates, but the chance for the eventual rate level to be 400bp higher than one-year ahead market forecasts is very unlikely to say the least. In fact, the outlier risk of a 400bp drop in the Fed Funds rate on a hard landing would be assigned greater odds.
In the last month, momentum has also faded and started to turn negative. In 2023, valuation levels could prove a challenging obstacle without carry surprises to offset and the tailwind of momentum to support them.
But the world is still a tenuous place, with abundant geopolitical and economic risks, and it is hard to see the surge in global growth and risk-on appetite that would a trigger a large unwinding of the Dollar’s valuation premium in the near-term.
While not our base case, a sharp reversal in Federal Reserve policy amid a hard landing for the domestic economy could turn carry into a negative driver and lead the Dollar lower. Thus, a more lackluster showing by the Dollar is likely for 2023 when compared to 2022, but the expectations of a sharp reversal could be disappointed.
Source: Bloomberg; as of November 2022. The U.S. Dollar Index (USDX) indicates the general international value of the USD. The USDX does this by averaging the exchange rates between the USD and major world currencies. The ICE US computes this by using the rates supplied by some 500 banks. You cannot invest in an index and past performance is no guarantee of future results.
IMPORTANT INFORMATION
Unless otherwise stated, all data as of November 2022.
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