Perspectives

Fixed income markets rose in the fourth quarter amid growing confidence that central banks have succeeded in slowing inflation and will soon be able to pursue less restrictive policy. This modest rally nevertheless ended up being too little, too late to help the bond market avoid its worst annual performance on record and an unprecedented second consecutive year of losses. Sentiment among both investors and consumers may have reached an inflection point, but data continue to justify some measure of caution: inflation is still stubbornly above the Fed’s target, the labor market shows few signs of loosening, and corporations have yet to see a meaningful deterioration in earnings. Only the rate-sensitive housing market really stands out as a casualty of the Fed’s tightening campaign to this point. Whether the end of the cycle is imminent is likely to remain an open question, especially as investors await the realization of the “long and variable lag” that has yet to be fully reflected across so many segments of the economy.

The Treasury market posted a small gain, as three months of income was more than enough to offset a slight bear flattening of the yield curve. The FOMC raised the overnight rate 125 basis points during the quarter, concluding a year that saw it rise a total of 425 basis points. The Committee provided a hawkish update to its Summary of Economic Projections (SEP), raising the median estimate for 2023 by 50 basis points. In his post-meeting press conference, Powell highlighted structural labor market shortages and offered commentary consistent with the “higher for longer” narrative. For the period, short rates moved higher on the revised terminal rate projection, while rates further out the curve were generally contained. Inflation breakevens rose slightly, reflecting a lower implied probability of a policy error, while real yields were little changed.

Corporate credit rallied along with broader risk markets, as spreads tightened across the quality spectrum. The investment grade market reflected a benign outlook for credit, closing the quarter at its tightest levels since April and well inside its long-term average. High yield spreads compressed for a second straight quarter, but this strength wasn’t enough to void the sector’s worst annual performance since 2008. Credit metrics remain solid, with moderate leverage, debt service coverage near historical highs and manageable near-term funding needs. The default rate remains low, with idiosyncratic rather than systemically significant incidents driving a small uptick. Mortgages outperformed Treasuries amid a drop in rate volatility. Technicals in the space improved, as higher mortgage rates and slower seasonal activity produced lower origination and slower runoff of the Fed’s portfolio.

The disconnect between the Fed’s projections and market pricing has widened following the most recent SEP. The median estimate of FOMC participants for the overnight rate at the end of 2023 is 5.125%, up from 4.625% in September; the fed funds futures market sees a terminal rate of nearly 5% in June of 2023 and then two cuts by year end. There has also been a small but not insignificant chorus of economists calling for the FOMC to raise its target inflation to 3% from 2%, prompting objections that this would undermine the Fed’s hard-earned credibility. These are just two sources of tension in the rates market, and their resolution could have significant implications for both the level and the shape of the yield curve.

Our fundamental view of credit is broadly constructive, and we believe balance sheets in general are sound and liquidity is sufficient. But we recognize the potential for macroeconomic forces to alter this landscape and we don’t believe all these risks are adequately reflected in valuations. Consequently, our allocation to corporate credit is at the lower end of its historical range. Within the space, we see the best value at the front end, where higher quality credits in less rate-sensitive sectors offer attractive yields and compelling breakevens. We have also been able to identify names that we believe can improve their credit profiles independently of a challenging macro backdrop. Our exposure to mortgages is neutral, as we believe the benefits of lower originations and potentially lower rate volatility are offset by event risks surrounding quantitative tightening and middling spread levels.