Fixed Income Boutique

Overreactions?

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Yann Lepape

Head of Macro Strategy Platform, Portfolio Manager

Meet Yann

colin_ludovic

Ludovic Colin

Head of Fixed Income Opportunities, Portfolio Manager

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| Read | 4 min

The cycle and the spreads: 27 September 2022

  • Are central banks overreacting? Job data will tell
  • A mix of immediate and lagging effects
  • EM IG spreads have remained relatively stable but have not fared better than HY

Accelerated pace of rate hikes (almost) everywhere

2022-09-27_fib_tribune_chart1_en

 

No fewer than 11 central banks met last week to adjust monetary policies. This was a broad rate hike, mostly in line with expectations. Mainly, most of them steered toward further tightening.

Japan (no change) and Turkey (100 basis-points cut) were two outliers. However, the Swedish central bank surprised the market with +100 bps, probably because it only meets four times a year and had to pre-empt the "competition". Another special case was Brazil, which opted for the status quo and suggested its cycle of hikes was likely to end: first in, first out. It shows hikes have an end. But all eyes were on the US Federal Reserve.

As expected, the Fed raised rates to 3.25% (+75 bps), revised inflation forecasts upwards and growth forecasts downwards. But, above all, it raised its expectations for rate hikes – the so-called dot plot that the bank uses to signal its likely interest-rate path. The peak would reach 4.6%, probably in the first quarter of 2023, compared to 3.8% forecast in June.

The Fed has triggered a massive movement on all maturities of the curve. Chair Jerome Powell admitted in his comments that he was assuming the risk of slowing growth sharply and bringing it below its potential.

Are we witnessing an overreaction on the part of the Fed and other central banks, after they were slow to identify the inflationary push a year ago? Only time will tell. Some effects are already being felt (see next story).

A slowdown in labor supply (job openings) and a continued rise in the participation rate (labor demand) would reassure everyone – not just the Fed. The risks are rising that the Fed is pushing the US into a recession, whether it’s intentional or not. Given the strength of the labor market and balance sheets, it should be a soft one if it’s not coupled with a financial crisis..

Accelerated Fed tightening: the immediate and the lagging effects

2022-09-27_fib_tribune_chart2_en

 

The generalized higher rates combined to the ever-rising dollar are tightening the global monetary and financial conditions further. The environment was already tense, especially due to restrictive policies in China, Russia’s aggression on Ukraine and the energy crisis. Within a context of poor liquidity in financial markets, this amplifies the impact of outflows in bond markets.

To illustrate this fragility, the market reaction to the UK’s fiscal plan (sterling lost around 8% in the last two weeks) is a new shockwave that is further inflating the US dollar bubble. Its strength is increasing inflation in the rest of the world and hurting growth. It is starting to create wider issues, pushing for example Japan to intervene in the currency market for the first time since 2011 after the earthquake in addition to other Asian countries, as decreasing forex reserves are indicating. The Chinese central bank also announced measures to manage forex expectations.

Higher rates are also impacting the US economy. The construction and housing sectors have entered a recession that will probably accelerate due to the lag between policy rates and the real economy. This self-inflicted pain will be disinflationary in the coming quarters.

One last impact is the level of real rates, which are expected to be positive in the near future (depending on how they are measured). The US is already in positive territory, making fixed income an attractive investment solution for long-term investors especially if the expected global growth and inflation continues to slow down.

IG EM spreads have stabilized, but have not fared better than HY this year

2022-09-27_fib_tribune_chart3_en

 

Looking at the chart above, one could be forgiven for thinking that investment grade has been a safe place to be in emerging markets this year as spreads have only increased slightly. However, lower credit risk doesn’t necessarily imply lower risk of capital losses. Especially not when interest rates rise because higher duration in investment-grade issues means that the price impact of higher rates is much more negative than on shorter high-yield issues.

In fact, emerging markets investment-grade total returns have been -22.8% in the year to date, marginally worse than the -22.6% seen on high yields despite the brutal spread widening seen in the latter amid fears of defaults and portfolio outflows. The contrast is starker in the month to date, with emerging markets high yields returning -4.4% compared to -5.2% for high yields amid the global rates selloff.

As seen above, only single B-rated issuers are offering significantly higher spreads than their historical average, which can be interpreted as a reflection of their higher credit risk. But with a lot of negativities already in the price, we think investors already get appropriately compensated for the additional risk.

What about countries without market access? Out of the 16 countries with spreads above 1,000, six are already in default, eight are CCC rated, and only two are in the single-B category. Ecuador and Pakistan, both with bond prices already well below 50 cents on the dollar, the historical recovery rate after emerging markets sovereign defaults. We’ll leave the country-specific details for another publication. For now, we’ll just convey the message that we still find plenty of medium-term opportunities within the single-B category for investors willing to look through the short-term noise.

 

 

 

lepape_yann

Yann Lepape

Head of Macro Strategy Platform, Portfolio Manager

Meet Yann

colin_ludovic

Ludovic Colin

Head of Fixed Income Opportunities, Portfolio Manager

Meet Ludovic