After a challenging 2022, where rapidly rising interest rates depressed the value of bond portfolios, investors have found themselves on much firmer ground at the start of this year. Bond yields have returned to levels not seen in over a decade, providing a potential buffer against further rate increases and lingering market volatility. This buffer proved valuable in the first half of 2023, as the Federal Reserve continued its inflation fight with three 25 basis points hikes. The impact of rate hikes first struck the banking sector, which had already started to tighten lending standards. Then, attention moved to debt ceiling negotiations and renewed geopolitical tensions, bringing a potential economic slowdown seemingly closer. As we enter the second half of the year, the market is intently focused on the fundamental condition of the domestic economy and the potential for further Fed actions.
Interest rates: Are we there yet?
Throughout the first quarter, many market participants anticipated rate cuts as early as mid-2023, despite a lack of evidence that the Fed was successfully bringing inflation down to its targeted 2% level. At that time, we deemed this expectation unreasonable and adjusted our portfolios accordingly. Despite a 500 basis points upward movement over twelve months, the Fed's primary inflation measure, Personal Consumption Expenditures (PCE) core, remains at 4.7%, roughly unchanged from its mid-2022 level. The market has since aligned with our viewpoint and expectations for rate cuts have been pushed into 2024. We continue to believe that rates will remain at the current level or possibly experience one more hike through the rest of 2023 and into 2024. We see a path for the Fed to start paring back interest rates later in 2024, but the economic outlook offers anything but clarity.
The key to the Fed implementing rate cuts lies in the labor market. Presently, unemployment rates are under 4%, and job openings (labor demand) remain strong. This is reflected in the overall good shape of the consumer segment. Although minor cracks may be emerging, as seen in credit card delinquencies and other potential credit issues, consumers are faring well. A glance at travel bookings (airlines, hotels, cruise lines) and other service spending data reinforces this observation. Until we see a deterioration in spending and an increase in unemployment, we do not anticipate the Fed moving rates lower.
Higher rates stress and test banks
In March, markets experienced a brief panic when Silicon Valley Bank failed due to its ill-prepared investment portfolios for rising rates. Other banks faced similar challenges. The perceived impact, and subsequent panic, may have been exaggerated by market participants. Banks were already contending with higher interest rates and increased deposit costs. Lending standards had already been tightening in the late stage of the economic cycle. While banking issues may persist for local and regional banks in areas such as commercial real estate and other interest rate-sensitive parts of loan portfolios, larger banks and the banking sector should not encounter further issues to the extent initially feared by many in the market.
Credit comeback? Where we see value in bond markets
The days of zero-bound interest rate policies and low-yielding bonds are currently behind us. Income has made a comeback across the bond market. Presently, we see value in high-quality corporate bonds and selectively in mortgage-backed securities. The earlier banking issues widened corporate spreads and increased volatility. This presented opportunities for bond investors, but as we proceed toward a potential economic slowdown, it becomes crucial to monitor the credit quality of bond issuers. We believe investors can build portfolios yielding 5% or more without compromising credit quality, with attractive opportunities in corporate bonds rated in the high BBB and A range that haven't been seen in 15 years.
We also find value in certain mortgage-backed securities if your investment policy mandate allows. The mortgage-backed market is divided between newly issued securities with up to 6% coupons and more seasoned securities with 2% to 4% coupons, providing a range of investment options. This also presents an opportunity for active managers to add value with security analysis and selection.
Fixed Income Outlook: Mostly cloudy skies ahead
If we were to experience a recession, we think it would likely occur in mid- to late-2024. However, as we enter the latter half of 2023 with elevated interest rates, persistent inflation, tight lending standards, and mixed late-cycle data reports, questions arise. Will concerns about banks resurface? Will the lagged impact of Fed policy have further consequences? When will investor sentiment shift to risk-off? Investors seek answers to these questions as we progress through 2023. Having an investment manager who monitors all fixed income risks and can implement and actively manage portfolio strategies accordingly will help add value and navigate any market turbulence that may arise.