Monthly fixed income update - February 2023

Fixed income: stronger data drove rate expectations higher in February

Following strong performance in January, February saw a reversal of fortunes for most fixed income asset classes as stronger data drove rate expectations higher. Although, the relatively hawkish statement from the Federal Reserve signalling that further rate hikes would be needed had little impact, the strong US employment report followed by US inflation not falling as quickly as expected caused a re-evaluation of how high the peak in rates across developed markets would need to be. This repricing of rate expectations drove yields higher, with longer duration assets generally having the worst performance in February.

Government and Inflation-Linked Bonds

Returns on both government and inflation-linked bonds were negative for February as yields rose in reaction to stronger data and higher interest rate expectations. However, while yields sold off during the month, breakeven inflation rates widened meaning that real yields on inflation-linked bonds rose by less than yields on government bonds. This led to US TIPS and EUR-denominated inflation-linked bonds outperforming their respective government bond markets. Although breakeven inflation rates also widened in the UK, it was not sufficient to offset the much longer duration of the UK index-linked gilt market which underperformed conventional gilts in the rising yield environment.

US Rates

The yield on the benchmark 10-year US Treasury rose by 41bp in February, reversing all of January’s gains. However, it was the front end of the US yield curve that was most affected by the higher rate expectations with the 2-year US Treasury yield rising by 62bp to reach a new cycle high. This also led to the yield spread between 2-year and 10-year Treasuries hitting new cycle lows of -90bp. The 10-year breakeven inflation rate widened by 13bp on the month as the annual rate of both headline and core US inflation fell by less than expected with the 10-year real yield rising by 28bp.

Eurozone Rates

Eurozone government bonds also sold off in February. The ECB delivered the expected 50bp hike at the start of the month but, with inflation remaining elevated, are expected to tighten policy further. Like US Treasuries, 10-year German Bund yields gave back all of January’s gains, rising by 37bp to reach a new cycle high of 2.65% at month end. German 10-year breakeven inflation rates widened sharply, up by 37bp leaving 10-year German real yields unchanged. Overall, eurozone inflation-linked bonds materially outperformed their conventional government counterparts over the month. With inflation and rate expectations being the primary market drivers in February, spreads between core and peripheral markets were rangebound during the month.

UK Rates

The gilt market was not immune to the bearish tone with 10-year yields rising by 38bp to the highest level since the market recovered from the fiscal loosening and subsequent policy reversal last year.  UK breakeven inflation rates also widened but only by 14bp leaving 10-year real yields 24bp higher for the month.

Investment Grade Credit

The rising rate environment also had an impact on credit markets and the bearish tone, along with a marked slowdown in net inflows, halted the spread tightening seen in January. Although spreads on EUR-denominated credit were slightly tighter, with flows continuing to favour the European market, they gave back some gains in the second half of the month. However, the prospect of higher rates and therefore slower growth caused spreads on USD- and GBP-denominated credit to widen over the month.

High Yield and Subordinated Credit

There didn’t appear to be a common theme across traditional high yield and subordinated credit markets in February. While spreads on traditional USD high yield were slightly tighter (7bp), EUR-denominated high yield performed better with spreads tightening by 22bp.  Euro corporate hybrid spreads tightened by 3bp, roughly in line with EUR-denominated investment grade credit. However, AT1 spreads widened.  While there were some idiosyncratic events around bank earnings, it appears that AT1s spread tightening paused having rallied hard in January.

Fixed Income ETF Flows

Following a record month for net new assets in January, the change in sentiment towards fixed income also had an impact on net inflows into fixed income ETFs in February. At just $0.5Bn, the value of net new fixed income ETF assets was the lowest monthly figure since last September when flows were negative.

With flows being so low, it is difficult to pick out specific themes as some of the idiosyncratic flows that took place are more noticeable. However, credit inflows remain strong taking in almost $1.8Bn and the notion highlighted last month that investors are increasing risk appeared to hold with further inflows into high yield and emerging market debt, albeit at a much steadier pace. 

Meanwhile, there continued to be outflows from cash management and floating rate note ETFs, possibly signalling an interest to move out of one of the lower risk sectors and potentially take on more interest rate risk as yields rise, and markets have priced in further tightening from central banks. Overall, EUR-denominated investment grade credit (+$0.9Bn) led once again but was the only category that saw more than $0.5Bn of net inflows in February. Outflows were led by EUR governments (-$1.3Bn), with floating rate note (-$0.6Bn) and cash management ETFs (-$0.4Bn) the only other categories to see material selling. 

What's Next?

• Recent stimulus, and the race to “Net-Zero”(cutting greenhouse gas emissions to as close to zero as possible) spurring $8 Trillion a year of additional spending on materials globally is likely to have a material impact on inflation in the coming years. Baseline inflation forecasts assume flat commodity prices, in our view often underestimating future inflation given the green transitions’ likely impact on supply and demand dynamics. Specifically, the supply constraint in oil, gas and coal production before the supply of low carbon energy alternatives that are readily available are creating an energy supply constraint, whilst demand continues to grow. Thus, we believe that commodity price inflation will support a higher level of US CPI and that actual inflation will print much higher than break evens are pricing today.
• We expect real rates, defined as nominal Treasury Yields minus actual CPI, will continue to rise in a quantitative tightening world, and will spur bond investors to demand a positive real yield on intermediate and longer duration treasuries—that is, a positive real yield based on the factual inflation trend (rather than the inflation rate implied by the TIPS breakeven rate).

• If the Federal Reserve hits the pause button on rate hikes this spring, we believe the market is underestimating the risk of a bear steepening if economic growth or inflation proves resilient in 2023. As such, we believe there may be a better time later this year to strategically add to intermediate, and eventually, longer duration, high quality credit.