Dear Investors,
Fixed Income
Fixed-income markets often tell a story about the overall health and potential future direction of the economy and capital markets.
In the past, the yield curve has been a powerful predictor of future economic direction, including potential recessions.
Wells Fargo Advisors believes monitoring credit spreads may also paint a picture of market liquidity, and the perceived health of corporate balance sheets.
With a meaningfully inverted curve and high-yield spreads well below the July 2022 peak, the bond market is sending mixed signals.
Yield curve
The yield curve is essentially the difference between shorter- and longer-term interest rates.
The yield curve has been inverted since July 6, 2022, as markets anticipated multiple Fed rate hikes, pushing short-term rates higher.
Bond market conviction that the Fed will lower inflation closer to target levels combined with the prospects for an economic slowdown has kept longer-term rates relatively contained, resulting in yield curve inversion.
While an inverted curve has often been a predictor of an upcoming recession, using this indicator to time a recession can be challenging, as it may take as long as two years from initial inversion to recession.
Credit Spread
During periods of market stress, credit spreads have tended to move higher as investors seek out higher-quality fixed-income investments and the future becomes more uncertain.
Last year, high-yield credit spreads hit a high near 583 basis points (100 basis points equals 1%) over the 10-year U.S. Treasury yield, indicating economic concerns and decreased investor confidence in corporate balance sheets.
Recently, high-yield credit spreads have tightened to near 400 basis points over comparable Treasury securities. Current high yield spread levels indicate that the bond market’s near-term economic concerns have eased in recent months.
Sovereign Bond Yields update
FED, Neutral, FED expects 25bps rate hikes in March, May, and June before a pause in policy action into 2024. Expected terminal rate: 5.25-5.50%
ECB, Neutral, ECB expects a 50bps rate hike at the March meeting, followed by two 25bps rate rises in May and June. That said, firm inflation signals, resilient activity and hawkish policymaker commentary presents upside risks to both our terminal rate projection and the pace of tightening. Expected terminal rate: 3.5%.
BOE, Dovish, BOE expects a final 25bps hike in March followed by an extended pause. Expected terminal rate: 4.25%.
BOJ, Hawkish, BOJ – The recent widening of the yield curve control band suggests this policy may be tweaked further or abandoned over the coming year.
Goldman Sachs also thinks there is a high likelihood of a rate rise and departure from NIRP.