“It does not matter how slowly you go as long as you do not stop.”
Treasury bonds rallied sharply in the fourth quarter of last year but have since sold off as the consensus narrative changed to view inflation as still high but declining. We continue to believe inflation will moderate without causing a recession in the US. The path to Federal Reserve (Fed) rate cuts will depend on the economy’s resilience; however, we see the current high rates above 5% as unsustainably restrictive for growth. Credit fundamentals support investment-grade quality and spreads, although absolute valuation levels are tight. Overall fixed-income sector performance improvement appears likely to persist, and we are especially constructive on emerging market (EM) bonds given the potential for rate cuts.
Key takeaways:
- Current high interest rates of over 5% are too restrictive, and a moderation in consumer spending will likely lead to the Fed cutting rates, though markets may move faster.
- Global inflation continues on a bumpy descent, providing flexibility for appropriate central bank policy easing amid slowing growth.
- Fundamentals and default risk support investment-grade credit quality, though valuations are somewhat tight historically outside of the post-global financial crisis (GFC) period.
- We continue to be constructive on the short and intermediate areas of both investment-grade and higher quality high-yield.
- Our base case remains that this continuation of widespread improvement in almost all fixed-income sectors since October should continue.
It hasn’t taken the bond market long to re-embrace the “inflation is sticky” theme, as Treasury bonds have sold off from their year-end prices. The spectacular 4Q23 Treasury rally was the largest on record. Treasury bonds rebounded as the then-prevailing narrative of perpetually higher-than-target (sticky) inflation and permanently elevated real rates changed swiftly. The inflation rate has since moved sharply lower to the 2% level on a six- and, by some measures, a nine-month basis. Fed Chair Jerome Powell and other Federal Open Market Committee (FOMC) members have now voiced that the path to cutting interest rates from currently restrictive levels will depend only on more “confirming” evidence (Exhibit 1).
Exhibit 1: Core Inflation, excluding Shelter, Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCE)
Sources: Bureau of Labor Statistics, Bureau of Economic Analysis, Western Asset. As of January 31, 2024.
Our view has been that the inflation rate would recede to Fed target levels without the necessity of inducing a recession. We continue to maintain that the path and timing of Fed rate cuts will depend primarily on the strength of the US economy, as the Fed is desirous to wait as long as possible. Recent economic resiliency has caused market reassessment of the timing of rate cuts. But the more important point, we believe, is that short interest rates of 5% or more are simply too high. Fortunately, the economy has been able to hold up, but we strongly suspect that restrictive rates, tighter credit conditions and, most importantly, a retrenchment from elevated consumer spending will bring a moderation in US growth. This will set the stage for the Fed to cut rates. The bond market may or may not wait for that eventuality. The current elevated level of interest rates suggests that investors should be willing to capture today’s longer-term Treasury yields. This is the reason the Treasury yield curve continues its multi-year period of being inverted.
The long investment-grade sector stands out as one where investors have been more than willing to lock in today’s elevated yields at the same time issuers have pulled back from borrowing. This relative dearth of supply amid ongoing investor demand has made this one of the best-performing bond sectors over the last year (Exhibit 2).
Exhibit 2: Investment-Grade Credit—Short Supply Amid Investor Demand
Sources: (A) BofA Global Research. As of December 31, 2023, (B) J.P. Morgan. As of October 18, 2023.
One of the anomalies of this market has been the avalanche of interest in private credit, even as most surveys show investor caution about public credit valuations. The backdrop for all credit is one of cash flow fundamentals and pricing relative to default risk. For investment-grade issuers, default risk has been historically very low. Current cash flow and debt metrics remain supportive. Margins have contracted, but from historic all-time highs. Which brings us to valuations. Currently they are tight by the standards of the post-GFC period. But we would point to the uniquely strong fundamentals, “locked-in” lower interest rates of investment-grade company balance sheets and the perspective of longer historical time frames (that weren’t subject to the deflationary risks of the dozen years before Covid), which all suggest today’s yield spreads are fair.
We have become cautious on long credit, specifically, as it has outraced so many other credit sectors. But we remain constructive on the short and intermediate areas of both investment-grade and higher quality high-yield. Investors are struggling to find yields exceeding the Fed’s 5%+ overnight rate. Given the prospect of only grudging interest-rate declines, this is a key consideration. Current economic resiliency is supportive, and over time, the Fed has the ability to provide interest-rate relief should the economy struggle. Still, in a sharper economic slowdown, maintaining credit exposure in shorter rather than longer duration spread product should prove relatively beneficial. And in such an environment, long Treasury duration would prove very helpful.
On the global front, we are constructive on many emerging markets, both in USD-denominated and local currency. On the latter, this year has the potential to be a watershed. EM countries have been ahead of developed market (DM) countries in terms of their policy-tightening the last two years. They are now in the position to be able to cut rates. This should be combined with reasonably stable currencies, and in that event, total returns could be significant.
While there is much talk of de-globalization (the withdrawal of DM countries’ manufacturing processes from EM countries), we think a reconfiguration is a better description. Supply chains are being rerouted to countries that are seen as very unlikely to be geopolitical adversaries. India, for example, has benefited versus China. Closer to home, Mexico has been perhaps the primary beneficiary, and we believe this trend will continue.
Global growth has shifted down, and global inflation continues to recede. Indeed, China is actually in deflation. The challenge for central bankers will be adjusting interest rates downward in an appropriately timely manner. Currently, US growth is the best in the field, giving the Fed leeway to wait. But as the trends of declining inflation (as uneven as it is) and moderating growth become more pronounced, the Fed is likely to respond. Our base case remains that this continuation of widespread improvement in almost all fixed-income sectors since October should continue.
Definitions:
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
The Consumer Price Index (CPI) measures the average change in US consumer prices over time in a fixed market basket of goods and services determined by the US Bureau of Labor Statistics.
The Core Consumer Price Index (Core CPI) excludes the prices of food and energy, which are volatile on a monthly basis, from the basket of goods used to determine the CPI.
The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.
Deflation refers to a persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money.
A spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.