Despite a prolonged period of tough monetary policy, central banks continue to fight inflation. Ariel Bezalel and Harry Richards would argue, however, that inflation is really last year’s concern and that weak growth will soon become the main obsession of the Federal Reserve and its peers. How should bond investors approach such an environment? Ariel and Harry give their view in this article.
Central banks remain obsessed with inflation, but we expect it to come down swiftly. What policymakers should be more worried about is growth – there are a lot of signs that point towards softer growth ahead and we find it hard to see how the US avoids a hard landing.

One key rationale behind our view on lower growth and lower inflation ahead is the extraordinary amount of tightening that global economies have seen in the last 15 months. US money supply growth is seeing the fastest contraction since the 1930s (the picture is similar in Europe and the UK).

Monetary policy acts with ‘long and variable lags’. The bulk of the US rate rises happened only in H2 2022, so haven’t hit the economy yet. We expect an easing cycle to begin, led perhaps by emerging market central banks, with the Federal Reserve cutting rates around the turn of the year.
Small banks, big problems
One key topic of recent months has been US regional banking. While investors in March were mostly worried about a run on deposits driven by credit risk in specific financial institutions, the problem is more structural. Deposit rates offered by commercial banks today (around 1%) in the US are well below the yield offered by money market funds (above 5%). The search for yield will continue to drive savings outside banks, reducing the deposit base. The data shows that this is already hurting lending. Bank lending, especially from smaller banks, is a crucial determinant of economic growth.
Yield on US money market mutual funds vs. national average yield on money market accounts
Small banks today lend roughly 2.5x more than large banks to the commercial real estate sector. Property refinancing will be increasingly hard (and more expensive), while vacancy rates on office property have touched historical peaks. Smaller banks are also key to providing lending to small and medium-sized enterprises who cannot access capital markets like the big companies can. That matters because these businesses provide about half the jobs in the US economy.

The historical relationship between tightening in lending standards and increases in unemployment is clear:
Lending standard surveys vs. unemployment - USA and Eurozone
Slowdown signals
The yield curve continues to showcase a meaningful inversion. Leading indicators and regional surveys continue to deteriorate. Corporate bankruptcies are already at the highest level year to date since 2010. US excess savings are running low, especially in the lowest income deciles. Housing markets look extremely fragile when facing persistent increases in mortgage rates. More timely indicators of job market health show a slowdown in employment.
Getting more cautious on credit
With the end in sight for rate hikes from central banks we continue to increase our strategy’s exposure to government bonds, but given our economic outlook we have been getting more cautious on credit.

Credit markets, led by the high yield market, have continued to perform pretty well, and are not pricing the slowdown we foresee. We have been gradually reducing our credit exposure and are likely to continue to do so in the coming months.

In the meantime, focus remains on defensive sectors, secured structures and preference for bonds with short maturity or close call date.
Markets may experience some turbulence…
A peak in the hiking cycle is usually a good sign for bonds. As risk-aware investors, though, we must consider the possibility of a bit of an air pocket in the coming months as liquidity deteriorates.

Now that the debt ceiling has been lifted, the replenishment of the US Treasury General Account will imply a meaningful increase in the issuance of T-bills and Treasuries. That will extract a meaningful amount of liquidity from the financial system, at a time when the Fed is already undertaking up to $95bn per month of quantitative tightening.
…but the outlook for fixed income is positive
Notwithstanding those possible short-term technical factors, fixed income investors have much to feel positive about in our view. The end of hiking cycles have tended to be a buying opportunity, as shown by the past performance of the US Aggregate index in the 12 months following the last hike from the Fed (see chart below).

The outlook for credit is more nuanced as the global economy slows down: default rates are likely to rise and some companies will find that their capital structure is no longer tenable with higher borrowing costs. However, the data shows that at these levels, high yield has historically delivered a positive return over 12 months most of the time, and delivers double-digit performance over half the time. If investors can avoid the losers, there are exciting opportunities in the market and we remain invested, but with caution.
Fed funds target rate vs. 2 years tresury yield vs. Bloomberg US Aggregate returns 12 months after the peak in rates
Time will tell whether the Fed agrees but, as we see it, the macro data is pointing in a direction that will make continued hawkish monetary policy untenable over the next few months. That’s an opportunity that bond investors should seize with both hands.

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