After dropping 17.5% in 2022, its worst performance on record, the US 10-year treasury bond shed a further 1.3% in 2023 as surging inflation prompted the US Fed to embark on one of its fastest paces of rate increases in recent decades. The yield curve has since adjusted to this new reality and the risk reward of owning bonds versus equities has tilted towards the former. With recession risks looming and the inflation outlook having stabilised, fixed income looks set to regain its “safe haven” crown.
Higher for longer
Striking a balance between overtightening and not restricting monetary policy enough is a major challenge facing the Fed. After reaching a peak of 9.1% in June 2022, the US CPI printed a much lower YOY reading for 12 consecutive months thereafter, closing in on 3%.
But inflation risk remains. Buoyed by strong consumer demand, high oil prices and a stubbornly low unemployment rate, the CPI is now ticking back up just shy of 4%, well above the Fed’s 2% target, reason enough for it to indicate in its last policy meeting that high interest rates are here to stay.
A look at 10-year real US yields (2.4% at the time of writing) indicates that we are in a sufficiently restrictive monetary environment., making it unlikely that the Fed will continue pushing rates further. With the odds of a rate hike dissipating, bonds should start to perform well in the short to medium term.
The fact that inflation is proving difficult to tame means that we will have to get used to a new normal of high interest rates, at least in the current macroeconomic environment.
Invest across the curve in quality
Timing the market is a question of luck rather than skill. Investing requires patience and a long-term view, hence it is difficult to know exactly when things will shift. It is crucial to diversify across asset classes, while for bonds, duration positioning needs careful planning.
Long dated maturities tend to be more volatile than shorter ones, but the latter pose re-investment risk. Should the “soft-landing” scenario fail to materialise, interest rates could drop faster than the market anticipates. Even if we do manage to avert a recession, the yield curve is already pricing this scenario. In either case, when we look at long dated real yields or short-term nominal yields, both look attractive, with short duration protecting against volatility and long dated locking in long-term returns.
High yield spreads are trading at around 400 bps above the US ten year, and we expect these to increase since we know low quality companies are already feeling the pinch of high financing costs and tighter lending standards. Because monetary policy operates with a lag, we typically start seeing defaults rise within the year after interest rates have peaked. In such a cycle we recommend investing in high quality, cash rich issuers.