Fixed income markets were effectively flat in the fourth quarter, despite major narrative shifts with respect to inflation, monetary policy, and COVID-19. Signs of easing supply-chain pressures and continued labor market normalization were not enough to quell concerns about rising inflation, which printed at its highest level in almost 40 years. The Fed executed a “hawkish pivot” in acknowledging more persistent inflationary forces and signaled their intention to respond accordingly. The extremely contagious Omicron variant rapidly established itself as the dominant strain around the globe, forcing a reappraisal of reopening timelines and reviving the specter of lockdowns and healthcare rationing. Ironically, the combined effect of these various forces essentially netted to zero; solid economic data and a broadly constructive outlook from the Fed were met with the prospect of tightening financial conditions and growth fears posed by omicron. But trading overall was orderly, and after the last two years investors seemed well practiced at looking past near-term volatility toward the next stage of a return to normalcy.
Treasuries posted a small gain, but it was not nearly enough to avert the first annual loss for the sector since 2013. The yield curve experienced a significant flattening as it became clear that the Fed no longer regards inflation as a “transitory” phenomenon and plans to act aggressively to cool it down. At their final meeting of the year, the FOMC announced an accelerated pace of tapering and projected an additional two hikes in 2022. Consequently, rates at the front end jumped to their highest level since prior to the pandemic, while long rates pushed lower despite slightly higher inflation expectations on weaker growth estimates. The revised dot plot finally aligned the central bank’s projections with market expectations for 2022. Mortgage-backed securities underperformed Treasuries as a result of a deteriorating technical backdrop. The accelerated pace of tapering and uncertainty around reinvestments weighed on MBS spreads, though this was partially offset by a seasonal slowdown in originations and higher mortgage rates.
Corporates experienced a minor bout of volatility as heavy news flow whipsawed investor sentiment, though much of the weakness could be attributed to technical factors. New issuance maintained a brisk pace even amid a backdrop of elevated rate volatility. Spreads widened slightly but nevertheless sit close to historically tight levels as credit fundamentals remain robust. Measures of financial distress are scarce and the default rates sit well below long-term averages. Companies have been disciplined in their financial policies, especially in the more cyclical and capital-intensive sectors, where excess cash flows have been directed toward debt repayment. Companies have taken full advantage of capital market access to lower interest expenses and extend maturity schedules, thereby reducing both the likelihood and severity of credit market distress.
The meaningful shift in the Fed’s reaction function—in addition to potentially elevated inflation pressure in the near term—suggest front-end maturities could face a challenging 2022. Farther out the curve, however, the outlook is less clear. With the Fed projecting a terminal rate near 2.5% and the market pricing in a ceiling closer to 1.75%, any fluctuation in this differential is likely to impact longer maturities most acutely as investors weigh the potential for a policy error. With respect to curve positioning, we think risks are fairly balanced.
In light of our constructive fundamental outlook for the credit market and still-supportive market technicals, we believe the corporate credit space offers attractive value. Additionally, with Treasury rates at historically low levels, corporates offer a competitive yield and the potential for spread compression in a rising-rate environment. While we are on guard against the potential for elevated M&A and an increased focus on shareholder returns, we see value in credit improvement stories within the investment grade space. In high yield, we favor crossover stories trading wide of investment grade peers while avoiding some of the more cyclical industries where we think good news is already reflected in spreads. We remain neutral on mortgages heading into the taper, though higher mortgage rates could improve our outlook for prepayment speeds. We also maintain our preference for higher-coupon, seasoned pools given our expectation of higher rates, as they are less exposed to extension risk.