The risks of elevated fixed-income expectations

Waiting for better entry points into risk assets

Financial markets enjoyed a near euphoric rally in November driven mostly by lower government bond yields but further helped by narrowing risk premiums. The U.S .high yield market generated its best return since July 2022, quite a remarkable event when the starting point for spreads was below the 10-year average, whereas spreads were about 150 basis points (bp) higher than average at the outset of July 2022.

Market dynamics shifted quickly in November, with fixed income and equities enthusiastically responding to economic data that showed a slowing economy. Core U.S. CPI coming in 9 bp lower than expected in October was sufficiently good news for the Russell 2000 to have its best day in over a year, gaining 5.4% on November 14.

The market appears convinced that a major pivot from the Federal Reserve is coming. Even if macro data points are moving in the right direction, we expect data to be noisy going forward, with the market priced for good outcomes on multiple fronts it will not take much to disappoint elevated expectations.

As of December 3, more than five cuts of 25 bp are priced into the Fed Funds Futures curve for 2024. At the same time, credit spreads for high-quality high yield are at their lowest level in over 18 months. The combination of tight spreads and significant easing of monetary policy, which is priced into interest rates, is difficult to reconcile.

For rates to prove accurate, we would expect significant economic weakness, which would argue for higher risk premiums. For spreads to be sustained at current levels, robust economic growth is required, which would make it difficult for dramatic rate cuts to occur. The market appears primed for a 2019 type Fed pivot, but the reality is that core CPI is still running at 4% year over year and has now had three years of solidly above target inflation.

While risk assets give no indication that financial conditions need to be eased, there is rampant speculation in vehicles like cryptocurrencies, which is indicative of excessive capital remaining in the financial system.

For much of the past two years, the rates market has done a terrible job of accurately projecting the forward path of monetary policy, with a strong bias to cuts being about six months away. Additionally, the market has been eager to over-extrapolate recent developments. Just as we saw some outlandish projections for higher rates earlier in the fall, the narrative has flipped, and some commentators have called for even more cuts than are already priced for 2024.

The market tends to overshoot, and the process creates trading opportunities. While we may prove to have been early, we believe that November presented an opportunity to de-risk as valuations became increasingly stretched. There is inherent negative asymmetry in spreads most of the time in credit markets, which becomes particularly pronounced when spreads move significantly inside of historical averages.

We will be patiently waiting for better entry points into risk assets. Credit markets exhibit strong mean reverting characteristics over time. Since 2008, there have only been two calendar years where high yield spreads did not hit 500 bp: 2017 and 2021. With the 10-year average spread of about 450 bp, we think the starting point of 384 bp for December is clearly arguing for defensive positioning. We also see risks to taking on excessive duration at current levels as the market has come a long way in a short period of time.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Fund Manager’s Commentary, November 2023. Used with permission.

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