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MARKET UPDATE

Q3 2023 Fixed-Income Overview

By Jeff Branstad, CFA, Model Portfolio Manager & Steve Lowe, CFA, Chief Investment Strategist | 08/01/2023

08/01/2023

 

Thrivent Asset Management investment leaders discuss the latest in the fixed-income market, including Federal Reserve’s inflation-fighting policy and how that’s impacted Thrivent’s positioning in the credit markets.

Jeff Branstad, CFA
Model Portfolio Manager
Steve Lowe, CFA
Chief Investment Strategist

Related content:

Q3 2023 Capital Markets Perspective


Q3 2023 Capital Markets Perspective Equity Overview


Video transcript

Branstad: Hi everyone, and welcome to Thrivent Asset Management's Fixed Income Overview for the third quarter. I'm Jeff Branstad, portfolio manager here at Thrivent. This is Steve Lowe, our chief investment strategist.

So, Steve, for our fixed-income segment, let's start where we always do: with the Fed.

Lowe: The Fed has been driving markets and will continue to into next year. They’re close to the end of a very aggressive hiking cycle. So, after a hike in July, with no meeting in August, there's a 50/50 chance that they [hike] more in September, depending on the flow of inflation data and the economy. So, [there would be] one or two more hikes and a pause. Then they'll be at the upper end of the range, which would be about 5.5 ­– 5.75%, which is well above inflation. That should be restrictive.

Inflation is falling, but the [Federal Reserve, or Fed,] has been relentlessly hawkish, so they're wary of taking their foot off the brake right now. The Fed expects to hold rates high for longer, through 2023 and into 2024. I think that increases the risk of a mistake.

When you look at market pricing, that shows that they’re expecting the Fed to cut in early 2024. We tend to side more with the market. I think the Fed will be forced to cut in the first half of 2024 as the economy slows and possibly slips into a recession, but that is far from given.

But inflation is already falling pretty steadily right now. It should cool further; in particular, we expect the job market to cool more.

It's important to remember that rates act with a lag – it takes 12 months or more for the full impact to be felt. It's not only [the Fed funds rate] that's impacting the economy. Banks are tightening credit across consumer lending, commercial lending, and commercial real estate, and that should slow the economy over time.

Branstad: What if the economy never really slows down and inflation continues to persist?

Lowe: That's a key risk. And it's already happened to some extent because inflation was far more persistent than the Fed and markets expected. In particular, if you look at core services, which the Fed is very focused on, that's come down, but it's still much higher than pre-pandemic [levels], and that's very wage driven. So, one of the key concerns is the core service component and if it doesn't come down, it's going to either [force the Fed to keep rates] higher for longer or increase again, both of which are not good for markets.

But if you look at consumer price inflation, it's already fallen from 9% to 3%. Goods, which popped during the pandemic – like car prices and bikes, among other things – that has come down pretty significantly and services are starting to follow. You can look at producer prices – which some people call “factory gate,” or the input prices in manufacturing or services – those have fallen sharply from 18% to -3%.

Branstad: Okay. Could you walk us through your view? What do you see happening?

Lowe: Yeah. Our view is that the economy will slow and that will lead to lower demand and a looser job market and wages. Inflation is going to be volatile, but we think the trend is [downward] and that ultimately slower economy and lower inflation will allow or force the Fed to cut rates.

And if we're wrong and inflation is more persistent, then the Fed is going to raise rates more, and that increases the odds of a recession. And they are very willing to do that to beat inflation.

Branstad: So, let's assume that inflation continues to trend down. That means we're getting likely close to the end of the Fed funds hiking cycle and it will peak. How is that going to affect Treasury rates? Where are they going to go?

Lowe: Well, Treasury rates this year have been quite volatile, buffeted by the ebb and flow of economic and inflation data. Considering post-banking issues, they plunged, especially Fed fund futures – the market priced out a lot of Fed hikes. But that's reversed because the economic data has been more positive, and inflation is tailing off.

We think the peak in rates has passed. The high in the 10-year was in 2022 and the 2-year peaked in the spring. We think both of those will decline going forward.

So, we expect continued volatility, but the prevailing trend should be lower rates following dissipating inflation and a slower economy.

I also think that the curve will steepen and people should be positioned for the steeper curve that typically follows an inversion. An inversion happens as the Fed is raising rates. So, short-term rates would go higher than long-term rates, long-term rates reflect slower growth, and a steeper curve happens as the market starts pricing in Fed cuts.

So, a 2-year Treasury would start falling because that's more influenced by Fed rate cuts. While longer rates are steady, they may fall a little bit. Eventually they'll move higher over time as the market prices in a recovery.

Branstad: What does this mean for investors seeking yield?

Lowe: Well, yields are down a little bit, but they're still very attractive, particularly versus recent history. The short end of the curve – like Treasury bills – have been attractive because Fed funds are high; they're anchored by Fed funds. But the issue with investing that way is that you have reinvestment risk. In other words, if the Fed starts cutting and you're in a 3-month T-bill, you’ll have to roll it over into a lower rate. So, I think locking in long-term rates makes sense right now with the expectation of lower rates.

Credit is very attractive for a buy-and-hold investor, particularly if somebody needs yield. There's potentially market-to-market volatility if spreads widen and defaults increase, particularly in lower-tier areas like high yield.

So, we have a bias for getting yield from higher-quality [credit], particularly investment-grade corporates.

Branstad: So, we've talked a lot about rates, but you've started to touch a little bit on credit there, too. Can we dig in more to credit and go through your views in those spaces?

Lowe: I think credit looks rich. It's partly been supported by demand for yield and investor flows, and some of the markets are supply constrained. I think that, heading into 2024, I’d rather take interest rate risk than lower-tier credit quality risk. Credit spreads are below average and they’re pricing in a pretty benign market – they're definitely not set up for a recessionary outlook or a slower economy in which spreads would increase significantly and you’d see an increase in defaults.

Looking at investment-grade corporates in particular, we like the risk/reward of those. They're higher quality and they're more rate sensitive, so you'll get a tailwind from lower rates, and they hold up a lot better in a slower economy. They have better access to capital, which is important. There's minimal default risk.

[The high-yield segment] has done well this year; lower quality has outperformed. But if you look at spreads, given the risk, they look very rich to us, and it's priced for a soft landing right now. There's not a lot of room for spreads to tighten. We think that, going forward, there will be an opportunity to buy high yield [for much less] as the economy slows or defaults rise. We don't expect a huge default cycle, but we still expect defaults to rise. And, in particular, if [we see] high-yield spreads somewhere around 600 basis points over Treasuries, we'd be very interested in it, and at 800 basis points, we'd be adding very, very aggressively. Now, I doubt we get to that level, but the 500 to 600 [basis point range] looks very attractive. Again, for buy-and-hold investors, they look very attractive, particularly if you can take that volatility.

Branstad: So, what about some of the smaller market segments like leveraged loans?

Lowe: For leveraged loans, the credit quality there has deteriorated pretty significantly. Returns have been good because of the floating rates, but the leverage is much higher than history and they'll get hurt a lot more in a recession. They tend to do better in a rising-rate environment from a total return perspective; that tailwind is likely gone now.

If you look at emerging markets, that also will be helped by lower rates. It tends to be a very long-duration asset. And so, again, lower rates act as a tailwind. The other thing with emerging markets is that the dollar has been weakening, and we expect it to continue to weaken. That should be a tailwind to emerging-market economies.

Looking at another area of the fixed-income market: preferred [securities] look cheap. They've been hurt by the banking issues because banks are major issuers of those. But, we still think, overall, particularly of the larger banks, the quality in their balance sheets are very strong.

Branstad: Excellent. Thank you so much, Steve. That's an excellent overview for the fixed-income markets.

And thank you all for joining us today. Please remember to visit us at thriventfunds.com for more insights and we'll see you again soon. Thank you.

Lowe: Thank you.

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