Yields are having their day
Yields are having their day
Today’s yields have not been this attractive since early 2019. However, the leadup to this point has challenged investors because the significant rise in yields, which began in mid-2021, has led to poor performance in the US bond market this year (as measured by the Bloomberg US Aggregate Bond Index). The index has declined 6.3% YTD, marking its biggest peak to trough decline since the late 1970s, even exceeding its fall during the Global Financial Crisis.
The recent weeks’ surge in yields comes on top of a significant re-pricing of yields across the curve over the last six months, most dramatically at shorter maturities. Additionally, credit spreads are now roughly 20% wider than the highs we experienced in 2021. Excluding the Federal Reserve (Fed) hiking cycle of 2018, yields available to investors are now more attractive than they have been at any point during the last ten years.
The rise in yields accelerated over the last month as volatility spiked due to the Russian invasion of Ukraine and historical global sanctions. The expectation of additional war-related inflation impulses, particularly related to energy and food, have further driven yields. The Fed delivered a widely expected 25 basis point hike on March 16th – the first hike since December of 2018 – and followed with the most hawkish statement of a generation. The market is now expecting more than 200 basis points of rate hikes over the next 12 months.
The Schroders US Multi-Sector Fixed Income team spent considerable time discussing markets at our Fixed Income Quarterly Investment Forum. Raising the Fed Funds Rate without causing a recession is always difficult and the war in Europe has made this hiking cycle even more challenging. Monetary tightening usually ends with a financial crisis or economic contraction. Although the war in Ukraine has extended the inflation cycle, we believe the Fed is unlikely to realize current market expectations for three main reasons:
- Mathematically, inflation calculations should decline as the high inflation prints of last years’ reopening roll out of the annual calculations.
- Declining real incomes will reduce consumption and investment – growth indicators are already slowing.
- Historically, the Fed doesn’t have a particularly good track record of delivering as many rate hikes as it indicates in its formal press releases (see endnote for a few examples).
Across the platform, we are looking to increase risk moderately given the higher yields/spreads available. The swift re-pricing of fixed income broadly has opened up value across a number of sectors (Figure 1). We are focusing on higher quality corporate bonds, which have underperformed lower quality in the recent sell-off, while using Treasuries and Agency MBS as a funding source. As liquidity recedes, other general market opportunities include attractively priced corporate new issues. Investment grade bonds afford relative protection against a slowing economy and a generous breakeven yield. Short corporates now offer compelling valuations as yields would have to climb above the last decade’s high before investors would fail to profit.
Bottom line: We believe the Fed will not complete the rate hikes the market has priced in and investors may earn more than the carry implied by current yields.
 As of March 29, 2022.
i October 3, 2000 “Against the background of its long-term goals of price stability and sustainable economic growth and of the information currently available, the Committee believes the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the future.” https://www.federalreserve.gov/boarddocs/press/general/2000/20001003/
What happened? The Federal Reserve cut rates 50 basis points on January 3, 2001.
August 7, 2007 “Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.” https://www.federalreserve.gov/newsevents/pressreleases/monetary20070807a.htmWhat happened? The Federal Reserve cut rates 50 basis points on September 18, 2007.
The Fed dot plot from the December 2018 meeting, indicated an expectation of two more hikes in 2019. https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20181219.pdf
What happened? The Fed cut by 25 basis points on July 31, 2019.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.