Credit: A Narrowing Window for High Yields Part 1
- Yield curve inversions have been a good predictor of a turn in policy cycle
- Following inversion, on average the hiking cycle ends after 7.6 months, rates drift up by 55 bps
- Balance sheet reduction may end earlier than expected given rapid decline in bank reserve balances
- The case for fixed income remains strong, especially with Investment Grade markets
- Their yields of c.4.9% and relatively low default rates present a window of opportunity
Knowing when to pick your battles. Another meeting, another 75 bps hike. With outsized rate hikes having become almost the norm for investors’ expectations in 2022, the phrase “Don’t fight the Fed” — once used to suggest the endurance of a bull market under easy monetary policy — now serves as a barrier to risk-taking as the tide of liquidity goes out. The trick, in essence, is not just knowing how to align one’s investment appetite with central bank policy, but the harder task of anticipating when to act. While there are no crystal balls for market forecasting, we highlight a possible framework to anticipate the potential reversal from hawkish policy — seeing as tightening monetary policy had largely been responsible for the tumultuous performance of most financial assets in 2022.
The yield curve as a leading indicator. Looking at data over 40 years, the inversion of the US 2Y/10Y yield curve has been an effective leading indicator for a turn in the interest rate policy cycle — preceding five policy turns since the mid-1980s. This happens because a diminishing economic outlook is often first reflected in the yields of longer-term bonds, before the policy rate is subsequently cut to reflect the emerging reality of a growth slowdown. As it stands, the Fed funds futures curve is already reflecting this expectation with rate cuts priced in beyond March 2023.
A matter of time. A closer examination reveals that following curve inversion, on average (i) the hiking cycle ends after 7.6 months, and (ii) rates only drift up by another 55 bps before the policy shifts. An emerging crisis/slowdown can then result in rates moving significantly lower — averaging a decline of 4% in our period of analysis. This implies that income-seekers can begin to pick points of entry into fixed income when the yield curve flattens because risk-reward starts to turn favourable.
Given that (i) more than two months have elapsed since curve inversion in this 2022 hiking cycle, and (ii) yields have still drifted 150 bps higher since, the opportunity for investors to obtain higher yields before the end of hawkish policy may not be far away now.
What about Quantitative Tightening (QT)? While most commentaries focus on the asset side of QT, what matters for systemic stability under the Fed is the level of bank reserve balances under the liabilities side of the equation. The Fed maintains a preference to stay with a regime of ample reserves; while the Fed’s Senior Officer survey conducted in May suggests that respondents are comfortable with reserve levels similar or higher than that at end-2019 — which by our estimates point to c.USD2-2.5t as a comfortable estimate.
As scheduled, the pace of QT had doubled in September to USD95b/month (USD60b/month in US Treasuries and USD35b/month in MBS). With bank reserve balances hovering just north of USD3.1t, a rapid reduction in reserves could see terminal levels attained by March 2023 — implying that QT could end sooner than expected. Even under a more conservative estimate — with the Fed’s reverse repo facility (RRP) declining proportionately to bank reserves — QT could end by October 2023. While these estimates can vary, all signs point to this tightening cycle ending much quicker than the previous one spanning 2015-2019.
Investors should capture yields while they last. Fears of higher rates may have paralysed investors from participating in credit markets, but if history is any guide, this opportunity may be more fleeting than most expect. We believe the case for fixed income remains strong — especially with Investment Grade markets — given their yields of c.4.9% and relatively low default rates over the business cycle. Investors should take the opportunity while stocks last.
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