BSJT - Front-End Fixed Income: The Window Of Opportunity

2023-03-22 03:20:00 ET

Summary

• An active Fed means that investors may finally get some yield out of front-end fixed income. Inverted curves also mean attractive income with limited duration risk, in our view.
• We think that elevated inflation will likely keep the Fed hiking rates. Still, current valuations and a rapidly cooling economy suggest that fixed income has a place in portfolios.
• Recent data point to a slowing economy – perhaps a sign that the monetary tightening already underway is taking hold.

By Akiva Dickstein, Rick Rieder and Scott MacLellan, CFA, CMT

Behind the curve and rushing to catch up

With inflation soaring and the Federal Reserve moving to restrict monetary policy, markets have seen a sharp upheaval in fixed income. In response to solid job growth and elevated inflation, markets expect the Federal Reserve to raise the policy rate to 5% by mid-2023, well above estimates of the long-run equilibrium rate (Chart 1).

That’s not out of line with the Fed’s own projection, as the dot plot from the latest Survey of Economic projections estimates a rate of around 5.1% to 5.4% by year-end 2023. Over the course of history, this kind of policy overshoot is extremely rare, and we think front-end rates are reaching unusually attractive levels.

Chart 1: Unusually aggressive tightening cycle is priced-in

Source: Bloomberg, Federal Reserve. Data as of 6 February 2023. Forecasts are based on estimates and assumptions, there is no guarantee that they will be achieved.

Front end: Yield with limited duration exposure

In response to a more active Fed, the nominal Treasury curve has flattened and fixed income yields at the front end have increased meaningfully. Bloomberg data as of February 6, 2023 show that the 2-year Treasury rate has risen 370bps since the start of 2022, and currently sits at around 4.4%.

In contrast, the 10-year rate is currently lower at 3.60%. This suggests that markets see rates eventually returning closer to neutral after the current rate hike cycle.

With the curve mildly inverted, there is relatively little term premium in longer-term rates. Indeed, Federal Reserve economist estimates of the 10-year term premium stood at -0.77% as of February 3, 2023 (Chart 2).

Thus, investors extending out beyond front-end rates are bearing more duration risk without higher yields to compensate. Put differently, if we look at nominal yield per unit of duration that investors must bear at different points on the curve, the front end of the curve looks relatively more attractive than the long end of the curve (Chart 3).

Chart 2: Ten-year term premium remains low

Source: Bloomberg, Federal Reserve. Data shows the Adrian Crump & Moench 10 Year Treasury Term Premium estimate. Data as of 3 February 2023.

Chart 3: More yield “impact” at the front-end

Source: Bloomberg. Data shows the yield-to-maturity divided by effective duration, across various points in the on-the-run Treasury curve. Data as of 6 February 2023.

A slowing economy is good for fixed income

Recent data point to a slowing economy – perhaps a sign that the monetary tightening already underway is taking hold. The US nowcast growth index (the 12-month US GDP forecast based on BlackRock's composition of traditional macroeconomic indicators) has decelerated, cooling to around 1% from the previous 3.5% estimates in early-2022 (Chart 4).

The economic slowdown reflects several factors, including declining consumer confidence and more cautious business spending. In our view, a cooling growth trend could help the fixed income sector stabilize after months of losses.

Chart 4: BlackRock’s growth nowcast is easing

Source: Refinitiv Datastream, chart by BlackRock Investment Institute, 4 January 2023.

As growth slows, inflation could also begin to stabilize. We already see tightening financial conditions and reduced consumer confidence weighing on spending.

The read-through to consumer prices may have a lag of several months, and our Economics team sees Personal Consumption Expenditure (PCE) inflation slowing to 2.5% by year-end 2023 from the current 5.0% (Chart 5).

While we can’t rely too much on point forecasts given economic uncertainty, we believe that if inflation continues to ease in coming months as we expect, fixed income could see potentially attractive performance ahead.

Chart 5: Slowing growth could weigh on inflation

Source: BlackRock. Actual headline PCE figures are displayed for data up to December 2022 with BlackRock forecasts thereafter as of 2 February 2023. Forecasts are based on estimates and assumptions, there is no guarantee that they will be achieved.

Where we see the most value: High quality assets

Across the fixed-income universe, rates are higher; this is mostly due to rising risk-free rates as nominal treasuries have sold off sharply, with the 5yr nominal Treasury rate near the top end of the range of its 10-year history.

In contrast, the widening in credit spreads has been more modest, and at 77bps, the option-adjusted spread (OAS) of the Bloomberg US Corporate 1-5yr IG credit index is shy of the wide levels seen during stressful periods (i.e. 2016, 2020).

Thus, while risk-free rates are attractive in our view, we would lead towards a more cautious approach of gradually legging into spread sectors in case spreads widen further on the back of slowing growth.

Chart 6: Front-end credit spreads have continued to widen

Source: Bloomberg. Data as of 6 February 2023.

Bottom line: We think front-end fixed income looks attractive

While there may be some room for interest rates to move higher, we think the front end of the yield curve offers an attractive asymmetry and opportunity to capture yield.

This would especially hold true if the economy is slowing, as our economic indicators suggest. We think that for investors focused on yield, the flatness of the curve may mean enhanced capacity for income generation while limiting potential duration exposure.

This post originally appeared on the iShares Market Insights.

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