December 2022 | Fixed Income Commentary
Published on January 27th, 2023
After government bond yields increased substantially during the first nine months of the year1 , fixed income markets experienced a reprieve in the fourth quarter as two-year and ten-year US treasury yields increased by a modest 15 bps and 4 bps 2, respectively. The Current Income Portfolio’s fourth quarter total return was 1.2% gross, and 0.8% net, for an overall decline of -7.7% gross, and -8.2% net, during the 2022 year.
At the start of the quarter, inflation readings came in higher and more broad-based than financial markets expected indicating to us that the Federal Reserve would likely need to take an even more restrictive monetary policy stance to fight inflation.3 However, as the quarter progressed, financial markets apparently welcomed a reduction in the monthly pace of increases in the Consumer Price Index in October and November that signaled inflationary pressures could be easing.3 Taken together with recent softening in some macroeconomic data, this suggested to us that the pace of the FOMC’s interest rate hikes could slow in the months to come. In fact, by the end of the fourth quarter, Fed Funds Futures markets were already pricing in a Federal Reserve “pivot” (a shift in monetary policy action) that reflected expectations for the Fed Funds Rate to peak at 5% in July of 2023, followed by roughly 50 bps of interest rate cuts in the second half of the year.4
Although financial markets appear to have priced in expectations for monetary policy 4 cuts to begin in the second half of 2023, the Federal Reserve has reiterated its plan to maintain a restrictive policy stance5throughout the entirety of 2023. In the Federal Reserve’s Summary of Economic Projections (SEP) released in December 2022, not only did the committee revise expectations for inflation in 2023 upward from their September 2022 SEP release (f), but Fed Chair Powell also stated that “it will take substantially more evidence to give confidence that inflation is on a sustained downward path”.5 Additionally, according to the December FOMC meeting minutes, not one member of the Federal Reserve expects to cut policy rates in 2023.6 Over the course of the year, we think this will get resolved in one of two ways. Either the market will push out the time to first rate cut to 2024; or the Fed will begin forecasting a cut in 2023. The key determinant as we see it is likely to be whether wage growth, which is a driver of services inflation, is stickier than expected by the market. Goods inflation has already improved, and shelter inflation is beginning to moderate as well. Presently we believe the Fed has an incentive to insist that policy will remain restrictive, because any plans to be dovish in the future might spark an easing of financial conditions, possibly imperiling its war on inflation.
At the start of the fourth quarter, Fed Funds Futures markets projected the policy rate to peak at roughly 4.5% in mid-2023. By the end of the quarter, the market projection had shifted to a peak rate of 5% at midyear, followed by 50bps of rate cuts by year end. This policy rate path projection contrasts with the Fed’s recent release of rate projections (in the “dot plot”) as FOMC members expect rates to stay higher for longer.
We believe the U.S. economy is likely to enter a recession this year that is accompanied by a possible decline in corporate earnings. While this all sounds gloomy, in our view there are several factors that suggest a “hard landing” scenario, i.e. a deep economic recession (sometimes associated with a financial crisis) is unlikely. At present, it appears the labor market is quite strong7, middle-income households still hold some excess savings accumulated over the pandemic period8, and corporate balance sheets and profitability are currently in a strong position9. In addition, we believe the U.S. banking system is well capitalized, as demonstrated by the 2022 Dodd-Frank Act Stress Tests,10 while excesses in the capital markets, such as highly valued but unprofitable technology stocks, Special Purpose Acquisition Corporations, and cryptocurrencies have largely been wrung out of the system, in our opinion.
Additionally, while we believe the Federal Reserve is likely to pivot and begin to cut the Fed Funds Rate by the end of the year, we are uncertain as to whether inflation may prove stickier than what may be expected, especially in the services sector. Still, if inflation is subsiding by year end, and the central bank is both shrinking its balance sheet and holding the Federal Funds rate above 5%, this combination is akin to further tightening and suggests to us that real rates would effectively be rising as inflation is decelerating. If the economy were to enter a recession, the Federal Reserve would then be prompted to lower the Fed Funds Rate, in our view. Overall, we believe that we will most likely see a pickup in financial market volatility as well as the potential for wider credit spreads during the first half of 2023, before inflation eases and credit spreads rally in the second half of the year.
We view high quality corporate bond and preferred securities as particularly attractive in the current environment given our outlook for 2023. Although investment grade corporate fundamentals may have just begun to show minor signs of deterioration, they appear to be in a stronger starting position than in past cycles heading into a potential recessionary environment.9 Profit margins, leverage, and interest coverage are all at some of the healthiest levels that they’ve attained in recent years.9 Moreover, given the significant portion of the preferred securities market that is issued by banks, insurance companies, and utilities, many preferred securities operate in a regulated environment which monitors their capital levels and capacity to pay dividends.10,11 We believe financial issuers can also benefit from higher interest rates through increases in net interest margin, providing another tailwind for many preferred securities in 2023. Therefore, given our potential recessionary outlook, we consider our corporate bond and preferred securities selection able to withstand a moderate widening of credit spreads and pick up in financial market volatility due to their strong corporate fundamentals, solid balance sheets and regulated nature of their businesses. Our goal of reducing risk and enhancing income is unchanged, and we think high quality fixed income assets are uniquely positioned to deliver attractive risk-adjusted returns in 2023.
1Bloomberg: USGG10YR Index 12/31/21 – 9/30/22
2Bloomberg: USGG10YR Index 9/30/22 – 12/30/22
4Bloomberg: MIPR, Market Implied Policy Rate screen
9Bloomberg: STRTN GO Fundamentals / EBITDA Margin, Total Leverage and Interest Coverage
As of December 31st, 2022