May 17, 2022
Is it Safe?
By some measures, the selloff in the US fixed income markets has reached historic proportions. Whether measuring the return of the Bloomberg Aggregate Index, the High Yield Index or US treasuries, the selloff has been dramatic since the highs of 2020. For context, the current drawdown from highs for the AGG is close to -13%, and for TLT (long duration treasury ETF), it’s -32%.
Contrary to the last few decades, the correlation between equities and fixed income has flipped, and is now quite positive—meaning the hedge-like qualities of bonds have diminished, as fixed income has been declining at the same time as equities and credit. Federal Reserve tightening and generationally high inflation have put fixed income markets on the back foot. At Yieldx, we are observing some signals that point to a potential change in the fixed income and equity market relationship that’s existed in the recent past.
The Impact of Repricing in Bond Markets
In the beginning of the first quarter of 2021, there was very little risk premium priced into the market for potential Federal Reserve rate rises in 2022. The market was priced for a central bank on hold, with little sense of urgency. But the situation today is quite a bit different. After the major repricing in bond markets that has occurred over the last six months, the market is now priced for a further 180 basis points of rate rises this calendar year (on top of the 75bps the Fed already raised), and a terminal rate close to 3.2% by late next year.
Below, we show the chart of market pricing for the Fed overnight rate in December 2022. With signs that the peak of inflation is already behind us (note last week’s comments on breakeven inflation rates and CPI data), and the economy clearly downshifting from last year’s torrid pace, Fed rate hike premiums may be skewing the other direction at this point. In other words, a further weakening of the economy, decline in inflation or equity market weakness may engender rate hikes being taken out of the curve.
Changes in Market Behavior
Additionally, the market is starting to act a bit different. As one may have observed over the past few weeks, equity declines are no longer accompanied by declines in the fixed income market. The positive correlation we have witnessed over the recent past has begun to decline, as seen last week when fixed income yields failed to make new highs as the equity market made new lows. One can see the subtle shift in the chart below—while still positive, the degree of positive correlation is weakening (from .4 to .18).
We believe much of this is due to the risk premium that is now embedded in the front of the market for future fed hikes (before, there were no rate hikes to “take out” of pricing), and the slowing economic and inflationary signals that are flashing yellow.
Given the level of inflation, and the Fed’s singular focus on bringing rising prices back to target, we think should rates decline, fixed income performance should be led by the belly and the long end, as the front end struggles to remove much of the tightening in the curve. The front end of the corporate and treasury market holds value as a cash alternative given the attractive income, curve roll down and yield spread to most cash investments, but for capital appreciation, the belly and long end of the high-quality investment grade and US treasury market may once again be a great diversifier.