Fear and the Fed

The uncertainty of the Federal Reserve’s behavior, from dovish in 2021 to hawkish in early 2022 to “let’s see” more recently, has not inspired confidence in markets, judging by their performance last week. Chairman Powell announced an increase in rates at his May 4th press conference and noted that a recession in the US might be necessary to avoid the damaging effects of long-term inflation. But Powell also suggested a greater degree of flexibility in the Fed’s forward actions, implying that the Fed will not force the US into a recession if it proves unnecessary.

Thus, after months of hawkish arguments that suggested policymakers viewed the present expansion as immutable and invulnerable, Powell returned to a more pragmatic view that Fed policy is not set on an absolute, preset course. CIO’s view on where the economy is headed and the potency of the Fed’s tools differs somewhat from that of the Fed. Nevertheless, Powell has appropriately warned that only with low, stable inflation can the US enjoy a long and healthy economic expansion.

• Over the past week, particularly after Chairman Powell’s late-Wednesday message, investors retreated from riskier assets, fearful that the Fed will be forced to tame inflation via a recession. For equity investors, much uncertainty remains as to where long-term bond yields may stabilize and what economic growth will look like after higher interest rates have impacted consumers and businesses. With the yield curve still steepening from recent levels, bond investors fear the Fed’s work remains unfinished.
  
   
• Citi analysts do not believe yields have to fall sharply to stabilize financial markets. Instead, investors will have to find comfort in the fact that yields have largely risen as much as they will. If economic conditions don’t spiral downward, indiscriminate selling is typically a sign of a market nearing a bottom.

Portfolio Considerations

• High-yield (HY) bonds are debt securities issued by corporations that get a lower-than-investment-grade rating. As of May 5, US high-yield bonds have fallen 8.71% this year, compared with a 13% decline for the S&P 500 equity index. The recent selloff in HY bonds is largely correlated with a selloff in US equities, which in turn, was likely precipitated by rising Treasury rates. Since the start of the year, the spread on the HY index has widened over 100bps, from 278bps to 392bps. Increasing high-yield bond spreads – the difference in yield between HY bonds and Treasury bonds – usually coincides with a slowing or even recessionary economy, sharp equity downturns characterized by spikes in volatility, and higher US Treasury prices. Given CIO’s expectation of slower growth ahead, the combination of a reduction in top-line revenue and increasing cost pressures leading to much thinner operating margins could prove challenging for overall HY index returns, more so as interest costs rise.
• In the current market, quality is key. The search is on for higher-rated companies within relatively essential sectors that are likely to earn a high level of free cashflow, even if the economic situation deteriorates. CIO has been underweight US high-yield bonds this year, although remaining overweight in leveraged loans.