Yields of dreams?

In 2022, moving from equities to bonds was the ‘perfect’ trade – if your goal was to move from the frying pan into the fire.

However, as we move into 2023 we think the landscape has shifted to the point where fixed income could potentially offer attractive returns.

Resilience in the first quarter

The US is currently not only not in recession, but its economy is proving resilient in the face of higher yields. After a lengthy period where the financial markets stumbled under this challenge, the underlying ‘real’ American economy has yet to follow the recessionary path set for it by many forecasters in late 2022.

At the same time, the markets have become excited about the apparent peak in US inflation – in our view rightly. Indeed, if we take the US Federal Reserve at its word regarding its inflation goals, our focus should now turn to the labour market.

Sequencing and the American labour market

If, as seems likely, rates go high enough to drive up unemployment, we’ll eventually find ourselves in recession, and recessions typically mean difficulties for risk assets.

The longer economic resilience in the US can be maintained, the more the Fed is likely to talk and act hawkishly, and the more pressure there’ll be on yields to drift higher.  

After a strong rally in bond markets at the end of last year, there’s room for yields to move higher – the US 10-year Treasury yield fell almost 100bps from 4.3% to 3.4% as inflation numbers finally rolled over.

In our view, this means that it’s possible 10-year yields could move back above 4%. However, we’re not underweight in either duration or fixed income overall. We have to acknowledge that we’re late in the economic cycle and if there are potentially attractive fixed income returns on the table as a result, we would rather buy duration after a sell-off than aggressively position for bond markets to fall today.

The sequencing of events is important here. If we’re right and the economic data for the first quarter of 2023 doesn’t scream that a recession is imminent, then markets could still carry on as they are, with yields drifting higher from their current levels, just not in a threatening manner.

Looking ahead

No outlook can be certain, but by early in the second quarter we should have much better answers to three key questions:

1. Will the US economy buckle under the weight of higher rates?
2. Is Europe chronically more inflationary than the US?
3. What does China’s reopening mean for the rest of the world?

The first is the biggest and most pertinent. If a recession does finally materialise, then we think the current consensus that ‘any recession will be shallow’ will be difficult to sustain. Even when data is released, it will be impossible to know at that point how shallow or deep a recession would ultimately be, or how many quarters the downturn would last.

When the next recession does come, we think normal ‘risk-aversion’ behaviours will be re-established. At this point, we would expect duration to come into its own again, as risky assets might face difficulties.

Our logic is simple: when growth turns down, forecasts of inflation should also turn down. And as forecasts of inflation turn down, monetary policy is free to come to the rescue of weak growth.