Crossroads: Politics, Inflation, & Bonds

At the crossroads of politics and inflation sit all investments, including bonds. Earlier this year, fixed income investors were jolted out of their slumber as the Federal Reserve (Fed) took a much more hawkish stance to combat inflation. Just a few weeks later, Russia invaded Ukraine, which presented a whole new set of challenges that only reinforced the need for the Fed to act. It’s hard to overstate the magnitude of these two developments, especially since they occurred in such a short time frame and came on the heels of a global pandemic just two years prior. It’s fair to suggest the combination presents a seismic shock that will have repercussions in political capitals and capital markets for years to come.

With markets at a crossroads, there is a lot at stake for bond investors. In this note, we discuss the context and present views that will guide our strategy in the months ahead:

Move to neutral duration
Real yield opportunities are improving
Be judicious in credit
Municipals look attractive
Emerging markets may benefit

Both Ukraine and Russia are suffering significant direct consequences of the war. In Ukraine, thousands have been killed and millions have been displaced, all but assuring that Ukraine’s economy should grind to a halt. Ordinary Russians are also bearing the full force of international sanctions. For the rest of the world, the fallout is no less consequential—longstanding alliances are under unprecedented strain and new ones are being forged. Moreover, shortages and supply chain disruptions have extended across the energy complex, grains, metals, and chemicals, pushing global commodity prices meaningfully higher and restricting the availability of critical parts, goods, and supplies for manufacturers and consumers. Many economists expect the resulting spike in prices to detract at least 1% from global growth this year, with the brunt of negative growth being borne by Eastern and Western Europe.

The Fed’s reaction to the economic fallout from the conflict and its shift to a much more hawkish stance have the most important consequences for financial markets. It seems the Fed views inflation as a clear and present danger and it is staking its credibility on its ability to restore price stability to the U.S. economy. To no great surprise, markets have responded aggressively.

Goods inflation was already running hot coming into the year. The invasion has further inflamed concerns among the world’s central banks. The Bank of England implemented its first rate hike on December 16, 2021, and was joined by Canada on March 2, 2022, but it was the Fed that really changed its stance and dramatically shifted market expectations. In mid-January, the Fed ratcheted up its hawkish bias and signaled to the market its intent to start tightening monetary policy over the remainder of 2022 and into next year. At first, the message was measured and persistent, but following Russia’s invasion of Ukraine, the Fed’s rhetoric strengthened significantly, culminating with its first rate hike on March 16, 2022. Today, the federal funds market is now pricing in 250 basis points (bps; 100 bps equal 1.00%) of rate increases over the next 12 months.

Unsurprisingly, the entire fixed income market has undergone a massive duration rebalancing, reflecting higher inflation and a more hawkish Fed. Further out on the curve, yields have risen and the coupon curve has flattened, while yields at the very front end remain attached to the actual federal funds rate. Yields in the overall U.S. Treasury market are about 130 bps higher so far this year, which has resulted in a year-to-date, mark-to-market loss of more than 7%—the worst start to a year on record for fixed income. Importantly, the 10-year U.S. Treasury bond recently breached its long-term support level of 2.6%, which is a long way from the 0.5% it recorded as recently as August 2020. Its recent move higher has pushed yields into no man’s land with little technical support until yields reach the mid-3% level.

Beyond U.S. Treasuries, credit spreads in everything from government-guaranteed mortgage-backed securities (MBS) to the lowest-rated high-yield debt have widened as well. But, to be fair, spread widening has been fairly modest given the extreme volatility in the rates market.

Recalibrating the bond market

While painful, much of the repricing in fixed income was necessary in recognition that the extraordinary monetary policies implemented in 2020 in reaction to COVID-19 were not sustainable. Moreover, following the dramatic shift in the geopolitical landscape, supply chains will need to be reworked and the globalization trend of the past two decades should slow further. As a result, it is likely inflation will be higher, growth will be slower, and monetary policy will be tighter going forward. However, that does not mean a recession is imminent.

Today’s higher yields, wider spreads, and relatively flat yield curve better reflect the current economic backdrop and should allow credit to flow through the system in a more economically judicious and efficient manner. In the aggregate, this suggests to us that interest rates will likely continue to head higher in the coming months, but at a much slower pace than seen in the first quarter.

Credit spreads remain a wild card. Much of this year’s repricing appears to reflect the need to shed duration in the face of high inflation and a less accommodative Fed. Current credit valuations are more consistent with mid-cycle growth than fears of a hard landing. We have sympathy for this view, but we are uncertain about the pace at which tighter financial conditions will affect the real economy and borrowers.

From defense to offense

Pockets of value have emerged in parts of the market, and we have started to enact a more debt-friendly stance in our fixed income portfolios. In implementation, it is important that bond investors carefully calibrate 1. their investment horizon—don’t get too far out ahead of the trends, 2. diversify—multiple sources of income are your best way to protect against a surging macro backdrop, and 3. keep your cool—it’s important to maintain an unbiased approach and not get tethered to one position or view. Our clients should consider the following:

Duration. We started the year quite defensively positioned with respect to duration, but the recent sell-off—and its pace—allowed us to move back to neutral. We don’t think bond revaluations have fully run their course, but the pace should moderate. Current values have started to create some interesting value propositions for different types of bond investors. As we like to say, value is in the eye of the bond holder!
Real yield. We like positive real yields. Late last year, they were almost impossible to find. Today, the picture is much different. As investors shed duration earlier this year, bond yields moved higher across different segments of the market, some of which now offer positive real yields. This includes short-duration high yield, long-duration municipal bonds, emerging markets, and intermediate investment-grade credit (just barely).
Credit. Credit spreads are currently trading in the middle of this year’s range and trending marginally tighter. A macroeconomic backdrop of high nominal growth certainly supports credit quality in theory. But, we are cautious about the outlook. Our bias is to use the strength in the market to move up in quality and/or structure to capture yield. We also prefer to take more interest rate/duration risk as yields rise rather than go down in credit quality. To be fair, this trade requires patience but is one we plan to stick with as the year unfolds.
Municipals. Municipal bonds got hit particularly hard in the first quarter due to very long durations and a heavy concentration of individual investors. However, with municipal-to-Treasury yield ratios now close to and sometimes above 100%, the value proposition looks compelling. This is particularly true for lower-rated municipal debt. Credit quality is still improving and funding requirements are limited.
Emerging markets. The world has certainly changed when developed markets find themselves “behind the curve” in the fight against inflation while emerging markets take it in stride. Countries such as Brazil started tightening policy about a year ago and are much closer to the end of their tightening cycles than the beginning. Furthermore, several emerging economies stand to benefit economically (particularly Brazil, Peru, and Chile) as global supply chains are re-tooled away from Russia.

The short of it

To summarize, we think a massive shift in the global order is underway. Political shifts, policy shifts, supply chain shifts, pricing power, the balance between developed and emerging markets … they’re all in play, and bond investors have only begun to react. Our five-pronged strategy is intended to help bond investors protect capital, capture yield, and maximize total return in today’s rapidly changing market.

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