While the Federal Reserve manages to raise interest rates without triggering a recession, financial markets, the economy and the Fed have struck a “fragile balance,” said Steve Boothe, head of global investment-grade debt at T. Rowe Price.
“It’s a good time to invest in bonds,” he said recently at the mutual fund giant’s Global Market Outlook conference in New York. “We haven’t seen these kinds of returns in a decade. The excitement surrounding fixed income markets today actually has to do with the main reason you should own bonds.
These reasons include receiving an attractive cash interest rate and a direct line to capital appreciation.
After recently hitting a high yield of 5.5%, 10-year U.S. Treasury bonds are still high, ending the first trading day of the new year at 3.9%. Treasury recently hit a low of 3.79% on December 27.
The content of this fragile balance shows a delicate sense of balance between market rises and falls. Bulls believe interest rates are peaking and inflation is falling. The bears say labor inflation is persistent and a recession is imminent. The economy’s bulls remain strong and the manufacturing sector is expected to accelerate. While pessimists say the effects of rate hikes have lagged behind, the yield curve remains inverted and manufacturing sector reports point to a recession. Finally, bulls point out that there is still plenty of cash to invest, while bears believe earnings expectations are too high.
“You can design yield streams, high single-digit nominal yields without going beyond investment-grade core assets,” Boothe said. “But there are many short-term and long-term trends that seem to be reaching some sort of inflection point. Many of these factors will introduce some degree of risk into bond markets and other risky assets.
Trends reaching inflection points:
· Peak rates
· Peak inflation
· Maximum liquidity
· Peak China
· State-of-the-art housing
· Budget peak
· Peak credit
· Peak employment
Boothe said the Fed stopping interest rate hikes would bring some stability to the market.
Additionally, Blerina Uruci, chief U.S. economist at T. Rowe, believes the Fed will keep interest rates high for longer, even as the financial market expects rate cuts by mid of the year. She added that because the economy, particularly the job market, remains resilient, if the Fed were to pull back on its monetary tightening too soon, the economy could quickly slide back into a reacceleration of higher inflation.
She added that the Fed will need to detect signs that the economy is approaching a recession before ending some of the ongoing monetary policy tightening.
At the same time, some problems and frictions in the bond market are the result of too much supply, Boothe said. The increase in issuance of Treasury bills has caused a large number of bonds to enter the market at a time when the two main buyers – central banks and commercial banks – have withdrawn, creating an imbalance between supply and demand which led to a sharp increase in interest rate volatility. . However, this risk is coming to a head and the supply of bonds is expected to fall soon.
An interesting dynamic of this risk lies in attractive real returns. Following the theme of stability and instability, this also introduces a significant headwind into the economy as a whole.
Boothe added that an underappreciated dynamic is that the corporate bond market reacts opposite to that of the Treasury market. Investment grade bond issuance has declined significantly year over year, which has contributed to a very stable environment.
However, for American companies, which forgave their debts in 2020-2021, the bill is coming. They will have 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 view for 12-month default rates is that they will increase to 3.5% and that this high default rate could last for some time.
“The Fed will delay the idea of introducing rate cuts for as long as possible and prevent the market from pricing in cuts, despite significant progress on inflation,” Boothe said.
In addition, the regional banking system remains under stress, with bank credit spreads not having retraced their widening in March. It could also prolong the default cycle. Yet over the next 18 months, this historic gap between interest rate and credit volatility will narrow, and credit volatility will increase as interest rate volatility decreases.
Because longer-dated duration is complicated by the importance of risk at the long end of the yield curve, Boothe concluded that shorter-dated, higher-quality instruments appear more attractive. “Keep it brief and keep it high quality.”
Tim Murray, capital markets strategist at T. Rowe, spoke on asset allocation themes and said the economy is in a state of purgatory, where it appears it has avoided a recession, but will not see a full recovery until the Fed cuts interest rates.
His big theme was “Don’t be a hero” because the resolution isn’t coming soon. He advised researching asset classes and entry points where and when a recession scenario is priced in, but be prepared to wait for it to bear fruit. Murray added that portfolios must “consider both inflation risks and recession risks.”
At the same time, stock market performance was very heavy as valuations were distorted by mega-cap technology stocks, particularly the Magnificent 7: AppleAAPL, Alphabet (GOOG), Amazon.com (AMZN), Meta PlatformsFB – formerly Facebook (META), MicrosoftMSFT, Nvidia (NVDA) and TeslaTSLA.
Murray added that most fixed income asset classes offer attractive returns and investors should seek yield while waiting for this purgatory to end.
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