In that vein, the first three months of 2023 marked the second consecutive quarter in what is in all likelihood a newly minted bond bull market. No doubt, the bank crisis has increased uncertainty.
But the crisis may have introduced a major positive for the economy and markets alike: central banker caution.
With most developed market central banks hiking rates, flattening yield curves have become commonplace. But curve inversions are a different story, typically a sign of restrictive policy and notorious for portending recessions and/or financial calamities. Alas, with the US curve handily winning the inversion race, the Fed should have arguably heeded the warning and slowed its pace of hikes.
Prior to the collapse of Silicon Valley Bank (SVB), central bank rate hikes were widely seen as the main threat to the economic expansion. Reducing inflation was the singular priority of consumers and businesses, politicians, and, hence, central bankers. In the wake of the crisis, however, central bankers may be more balanced in their efforts to tamp down inflation given their newfound appreciation for unforeseen risks.
Ironically, markets may appreciate the more cautious approach to fighting inflation, even if that means taking longer to get it back to target.
The first quarter experienced a phenomenal shift in market pricing from expecting a string of rate hikes following the January 31 FOMC meeting to expecting a string of rate cuts as a result of the SVB/Credit Suisse (CS) banking crises. This swing in sentiment carried over to other DM bond markets to varying degrees. In Q2, the Fed and markets are likely to step back, reflect, and regroup as they struggle to evaluate the post-SVB landscape. Are there other weak links? What are the knock-on effects across the broader economy? While investors await answers during this interval, interest rates are likely to remain within the broad — even bipolar — range covered during the first quarter as they wait for the dust to settle.
With monetary policy posing the biggest threat to the economy, it’s no surprise to see that movements in credit spreads have closely corresponded with interest-rate volatility. To the extent that our “reflect and regroup” hypothesis and the range for interest rates plays out, we expect interest-rate volatility to decline and credit spreads to stabilise, or narrow, as economic uncertainty begins to clear. In fact, in the final days of the quarter, credit spreads narrowed, and the broader stock market rallied, suggesting markets are trying to move beyond the SVB/CS crises.
As 2022 came to a close and the relentless rise in bond yields began to level off, bond fund flows quickly flipped from outflows to significant inflows. In fact, a quick review of bond fund flows in recent years suggests that, unless rates are rising rapidly or volatility is soaring, fund flows have generally been positive and substantially so. That was true even in 2020, which was a time of extremely low yields. With yields now substantially higher, strong fund flows could provide an important tailwind for the markets as volatility begins to abate.
From a big-picture perspective, the high-yield configuration provides a positive backdrop for fixed income in general. Nonetheless, the outlook is hardly devoid of risks. Geopolitical strains pose further market risks. International divisions are flaring in the wake of the ongoing Russia–Ukraine war. During the next quarter or two, markets will have to grapple with the morass of a potential US government bond default. At this point, though, we see these risks as more peripheral than primary, but that could quickly change. As a result, we will keep our eyes and minds open while remaining prepared to revise our outlook as the quarter progresses.
Conclusion: Still “game on” for bonds but expect primary return drivers to rotate as Q1’s interest-rate driven rally gives way to Q2’s spread recovery as well as sector and issuer spread realignments.
Robert Tipp, chief investment strategist and head of global bonds, PGIM Fixed Income
