The View From the Peak

Despite hawkish policymakers and very mixed economic data, the approaching plateau in rates brings more clarity and conviction to our fixed income views.

The headline from our new quarterly Fixed Income Investment Outlook is that there is a lot more certainty now than a year ago.

Despite “hawkish pauses” and very mixed economic data, we think the path of inflation and rates is clearer. We also see this fundamental rates and inflation backdrop increasingly reflected in the dispersion of bond issuers’ cash flows and credit spreads, rewarding issuer selection.

It leads us to caution on duration, and to a laser focus on quality and cash-flow resilience in credit.

Epic Disinflation

Last week’s GDP and unemployment claims data provided more signs of a tight U.S. economy. Nonetheless, after 500 basis points of rate hikes, the U.S. Federal Reserve has engineered a disinflation that has been epic in size and speed, cutting headline CPI from 9.1% to 4.0%.

Similarly, the eurozone inflation rate of 5.5% might look sticky, but it too is down from a peak of 10.6%. The U.K. printed 8.7% inflation for two months in a row, but eight months ago it was 11.1%. It was still in double figures as recently as March.

Policymakers are taking no chances. Fed Chair Jerome Powell insisted last week that policy “has not been restrictive for long enough.” European Central Bank President Christine Lagarde said she expected to “continue to increase rates in July.” Markets now anticipate another 50-basis-point hike from the Bank of England’s next meeting, and additional hikes from the Fed and ECB in July, with no cuts in 2023 and only modest cuts through 2024.

This is all confirmation that the last mile of a marathon is the hardest—getting inflation back to target may well take another year. But that doesn’t change the fact that 25 miles appear to be behind us. We now think that core U.S. inflation could be around 4% at the end of this year and 2.0 – 2.5% by the end of 2024. The ECB projects 5.1% at the end of this year and 3% by the end of 2024.

That’s important context for current central bank rhetoric. Are there more rate hikes to come? Quite possibly. Are there a lot more rate hikes to come? We think not.

Declining Volatility

This feels very different from the high uncertainty of 12 months ago, when inflation rates were soaring, or even three months ago, when the mini banking crisis triggered speculation about early cuts.

We can see rising certainty in the declining volatility in bond markets. The MOVE Index of option-implied bond market volatility has almost halved since March. For three weeks, the U.S. 10-year yield had bounced around within a 12-basis-point range. (Last Thursday’s U.S. GDP upgrade gave it a meaningful boost above that range.)

We think that is the effect of the continued hawkish tone from policymakers setting a floor while the inflation outlook sets a ceiling. That is why we see no compelling reason to take more interest rate risk as long as yields remain higher at the front end of the curve.

Growing Dispersion

The peak in rates will come as a relief for some, but if they stay at high levels it will keep the pressure on. That is why we remain even more cautious on credit risk than on interest rate risk.

We see credit selection becoming increasingly important. Second-quarter reporting revealed growing dispersion in corporate earnings growth and cash flows that can be obscured if you look only at what’s going on at the index level.

Costs are elevated, including interest repayment costs. Right now, being able to grow revenues fast enough to absorb those inflated costs is the difference between stability and stress. Energy and gaming are two sectors that are managing to sustain cash flows; healthcare and media broadcasting are two that are struggling.

In addition, there are pockets of high-quality credit where valuations are attractive due to stressed sellers such as U.S. regional banks: we see opportunity in mortgage-backed securities and other securitized debt, for example.

In short, there is plenty to do in fixed income markets as we look to the second half of the year. And as the rate cycle approaches its peak, conviction in our views is growing.