The cycle pirouettes and fixed income dances to the fore

The opportunity in fixed income is more alluring today than it has been in the last decade. Even when we compare today’s yields to those available over the last two decades, we clearly see that several sector yields rise to the top quartile of their historical range. The best part is that it’s the highest quality, lowest risk sectors that offer the highest yields and best opportunities. Figure 1 highlights the favorable possibilities that now exist for investors. The potential profits this asset class may earn investors become even more unequivocal to us when we compare them to what equities now offer; to wit, the 2-year Treasury yield currently eclipses the S&P 500 dividend yield by 2.19% (Figure 2). For the first time in years, investors are well compensated to patiently wait in high-quality fixed income while the cumulative effects of the most aggressive rate hiking cycle in history have begun to impact the economy.

After peaking at 9.1% in June 2022, inflation now stands at 6.4% and is expected to fall below 5% over the coming months and remain relatively rangebound for the remainder of the year. We believe this is a juncture that provides a good entry point for investors. It is our view that most of rates’ journey upward has concluded. Dating back to the beginning of 2022 through today, the Federal Reserve (Fed) tightened monetary policy by raising the base rate, known as the Federal Funds Effective Rate (Fed Funds), nine times; four of these hikes occurred in 75 bps increments and the net effect has been an increase of 475 bps. During that period, there were no cuts. In contrast, since the end of the Global Financial Crisis (GFC) in 2009, the Fed hiked nine times and in turn cut nine times; the overall effect was an increase of 225 bps as well as a decrease of 225 bps, resulting in a net effect of zero changes to the Fed Funds rate (Figure 3). Interestingly, 2022 saw the most rate hikes in a calendar year in history.

In addition to the effects of the Fed’s tightening on Wall Street, Main Street is also showing signs of impact as reflected in the Senior Loan Officers Opinion Survey (SLOOS). The SLOOS (Figure 4) offers insight into the availability of and demand for credit among commercial and consumer borrowers. Loose underwriting standards and high demand for credit are generally a good leading indicator of an economic expansion. The last couple of quarterly surveys show just the opposite: tighter underwriting standards and lower demand for credit, which usually lead to an economic slowdown. Historically, fixed income outperforms when the market’s focus swings from fighting inflation to an economic slowdown.

Our preference is tilted towards high-quality sectors, such as Treasuries and agency mortgages, because they currently offer compelling income and liquidity characteristics. In terms of corporate bonds, credit curves are flat and the corporate credit spread to Treasuries as a percentage of total yield is low. As a result, we believe that the opportunities that offer the greatest potential rewards lie in short-dated, higher quality and more defensive segments of the market. With the expectation of a slowing economy creating dislocations and disruptions, we view the liquidity that these assets offer as an additional benefit; liquidity enables investors to efficiently pivot to riskier segments of the market once the impact of tighter monetary policy is priced into securities.

We emphasize that the unintended consequence of tighter monetary policy has been severe volatility in the financial sector. We expect financial institutions to hoard their liquidity and extend fewer loans, which will likely adversely impact prospects of economic growth. Should a crisis of confidence in banks persist, policymakers and regulators may institute systemic measures similar to those employed during the GFC to encourage clients to maintain their deposits so that banks can extend credit that facilitates global growth.

These new developments may influence the Fed’s rate hiking warpath. Historically, approximately one year after a hiking cycle begins, the economy starts to slow, and inflation stabilizes and begins to decline, leading to the end of the Fed’s hiking cycle. Once that happens, the market begins to price in rate cuts which creates attractive absolute and relative returns in fixed income. While the markets are forecasting a 50/50 probability of one more hike in May at the time of this writing, this hiking cycle, which commenced on March 16, 2022, just passed its one-year anniversary. In the past, the best time to buy fixed income has been thirteen months after the hiking cycle begins and following the penultimate hike (Figure 5). If history repeats itself, the best time to buy bonds would be around April/May of this year.

Given the considerable increase in yields over the last year, peaking inflation, indications of an economic slowdown and recent disruption among banks, we believe there is an imminent regime shift from focusing on inflation to prioritizing economic growth – even while inflation languishes above the Fed’s previously set target of 2%. In light of the new and evolving landscape, we conclude that fixed income offers a once in a generation opportunity on an absolute basis as well as relative to equities.