Morgan Stanley IM: Where Is All the Yield Going?

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With economies and corporate results strong, it is logical that credit and equity markets do fine. But, if everything is good macro-economically—and likely to stay good for at least another year—why are yields falling? The answer lies in expectations, market positioning and the Federal Reserve (Fed). And, maybe most importantly, the search for yield in an income starved world.

The key June event was the Fed’s mid-month Federal Open Market Committee (FOMC) meeting. The Fed signaled (via its dot-plot) a lift-off for policy rates in 2023, with the median expectation from committee members for two rate hikes, which is earlier than previously communicated at its March meeting. While Chairman Powell downplayed the change in the dots, stating that they would not change the Fed’s policy forecast until the FOMC saw “further substantial progress”, and that “liftoff is well into the future,” the tone of the press conference, the number of FOMC participants who brought forward their first hike expectations and the hawkish communications by President Kaplan of the Dallas Fed and President Bullard of the St. Louis Fed, among others, convinced the market that policy preferences had meaningfully changed. Maybe Flexible Average Inflation Targeting (FAIT) was already done!

The truly remarkable impact the Fed meeting had was on the shape of the U.S. yield curve and inflation expectations. In the 48 hours after the meeting (Wednesday to Friday) 30-year U.S. Treasury yields fell 19 basis points (bps) while the U.S. Treasury 5-year yield fell only 2bps. This belies the true volatility, as the markets traded chaotically post press release on Wednesday June 16. It is very, very unusual for long maturity yields to fall and the curve to twist/flatten like this before the Fed has even begun to raise rates. In addition, over the second half of the month, the forward yield curve between 5-year and 30-year yields almost went to zero, which historically has not happened until the Fed has almost finished tightening! Moreover, even though the Fed did not indicate that it would increase the cumulative amount of tightening over the cycle (e.g., the terminal Fed funds rate remained unchanged), the market believed the terminal rate would now be lower than before the meeting. Despite inflation surprising to the upside, inflation expectations, as measured by U.S. breakeven inflation rates, fell. Even more astonishingly, this dynamic played out in other countries as well.

Clearly, the Fed’s actions, although a surprise, was unlikely powerful enough to unleash the market moves witnessed. Other factors which contributed to the rally in government bond yields include: market positioning, particularly among speculative investors; concerns over growth slowdown in U.S.; the COVID delta variant and its implications; speculation that the neutral policy rate (i.e., r*) may have shifted lower; and excess liquidity/ savings. We believe worries about growth will subside; the delta variant will not derail economies normalizing given reduced hospitalization and mortality rates with growing vaccination levels; and, market technicals will stabilize (they always have). On the other hand, excess liquidity/savings might be here for a while, and it remains to be seen if r* has moved meaningfully, although it’s difficult to identify any data which supports such a change in view.

Credit and equity markets were fairly nonchalant by all of the hoopla in the government bond markets. Both IG and HY spreads continued to tighten, seemingly somewhat impervious to other forces, continuing to make new lows. If the Treasury market was signaling trouble ahead, risk markets were not listening. As we believe economic data will stay strong (meaningfully above trend) and inflation will not prove to be a problem, market worries about growth deceleration and the possibility of the Fed making a policy error by moving to tighten policy too soon look wrong, in our view. The global economy is doing better.

Display 1: Asset Performance Year-to-Date

^{Note: USD-based performance. Source: Bloomberg. Data as of June 30, 2021. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions}

Display 2: Currency Monthly Changes Versus U.S. Dollar

^{Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of June 30, 2021.}

Display 3: Major Monthly Changes in 10-Year Yields and Spreads

^{Source: Bloomberg, JPMorgan. Data as of June 30, 2021.}

Fixed Income Outlook

Despite all the Sturm und Drang of market action and confusing news flow in June (inflation, employment, supply bottlenecks), we do not believe there are big investment implications beyond the fact that risk-free government yields are getting as low as they likely can without a fundamental rethink about the trajectory of economies and policy responses. Looking at the facts, we can see business outlooks and confidence surveys at high levels; strong employment growth; strong productivity growth (no sign in margin squeezes); strong economic growth (as measured by GDP); easy monetary policy (U.S. financial conditions continue to set new levels of easiness) despite worries about the Fed and other, particularly EM, central banks tightening policy; and easy fiscal policy, at least in Europe and the U.S. While policy actions will not continue forever, U.S. supplemental unemployment benefits are slowly expiring, household and corporate balance sheets are flush, almost never stronger. An indication of how flush is the ratio of bank deposits to loans on bank’s balance sheets. Currently deposits are greater than bank credit! The need to borrow is low. And, deposit growth is twice as high as credit growth. Household savings rates are at very high levels, providing ample ammunition to fund strong spending for the next few years; ditto for corporations.

This leads to a critical question. Will savings built up over the pandemic be spent? As policy support inevitably fades, even if slowly, will private sector spending pick up the slack? Most likely yes, allowing the economic expansion to remain strong (albeit at lower levels than 2021) and continuing through 2022, pushing the U.S. economy to over full employment at sometime late this year or early next year. With U.S. financial conditions at historical easy levels and European levels moving in that direction, it seems unlikely that the economic cycle is anywhere near its end point. Indeed, with office workers just beginning to trickle back to office buildings, it seems perverse to think we are near the end of the cycle.

Despite the ongoing rally in credit markets, we believe a sanguine view remains appropriate. Strong economic data (even if decelerating, as U.S. H1 growth is unsustainable), strong corporate revenue and robust balance sheets remain quite supportive despite high valuations. Historically, we have seen credit spreads, both IG and HY, remain on the expensive side of average for long periods of time, especially when economic growth is this strong and monetary tightening is still far away. Moreover, with government bond yields still negative in much of the world, the search for yield is not likely to abate in any significant way. That said, it is dangerous to completely ignore valuations, so we continue to advocate a selective approach, looking for companies that will thrive in the post-pandemic world and not engage in too much creditor unfriendly activities. We do expect companies, in general, to be a bit more conservative in cash flow/balance sheet management after the searing pandemic experience in 2020.

The rally in government bonds is fast approaching levels which look too low relative to a sanguine view of the future. U.S. Treasury 10-year real yields are back near -1%, not far from lows seen in May or even during depths of despair in February 2020. This is not sustainable unless we are returning to a secularly stagnant world even worse than experienced prior to the pandemic. This could happen if the COVID epidemic has left permanent scarring on the economy, causing potential growth rates to be lower and hence also lowering the neutral policy rate to which central banks look to raise rates over time. Easier monetary policy is required to achieve the same growth and inflation rates that prevailed pre-pandemic. Japanification would be an apt description, where household savings stay high. Governments drop helicopter money (think MMT) and households and corporates recycle it back into bank deposits. Real yields and inflation are low; government debt is high; employment is high, but wage growth is low and growth anemic. We do not think this is going to happen to the U.S., China or EM (Europe remains a work in progress) but vigilance is required to monitor developments on the policy and private sector behavior fronts to make sure, the policy rug is not pulled out from under economies and the private sector remains confident enough about the future to increase spending and reduce abnormally high (by the standard of normal times) savings. 10-year U.S. Treasury yields look too low at 1.2%, as do 10-year German government bonds at yields lower than -0.4%. Duration management in the second half of the year may be critical to generating positive returns.

The bottom line is that an investment strategy focused on a continuation of low nominal (and in particular real) yields, strong growth (in output and incomes), rising vaccination rates, and stable policy remains intact. While it is difficult to believe that global developed market yields will not go higher eventually, we should not count on it happening in the very short term, given technical and liquidity dynamics at work (summer liquidity and of course the August curse when things seem always to go haywire somewhere in the world). Credit spreads should remain well supported but higher quality bonds will struggle to tighten further; widening should be a buying opportunity given the medium term outlook. Cyclical assets should continue to outperform, as we have seen CCC rated bonds do in recent weeks and months. Selective emerging markets and securitized credit remain attractive. As we have discussed before, the dollar remains a bellwether of where the global economy is going: weaker is good/stronger is bad.

Developed Market (DM) Rate/Foreign Currency (FX)

Monthly Review

In June, 10-year yields fell across the developed markets, despite continued strong economic data and muted volatility. In the U.S., the yield curve flattened meaningfully as rate hike expectations are forecasted to be sooner than previously thought following a hawkish shift in tone from the Fed at its June meeting, but the terminal, or neutral, policy rate is now being priced to be lower. U.S. 10-year breakeven inflation fell over the month, although investor concern around rising inflation remained. As vaccination roll-out continued to accelerate across the EU, the ECB presented a more positive outlook to the region’s economy at its June meeting. The ECB upgraded its GDP and inflation projections, while also viewing the increase in inflation as transitory. The Bank of England kept rates and asset purchases unchanged at its June meeting, despite rising inflation and stronger than expected GDP growth; the market interpreted the meeting as dovish due to the committee communicating it doesn’t plan to raise rates for quite some time still.

Outlook

Falling infection rates, vaccine rollouts and strong efficacy results, massive U.S. fiscal stimulus, high savings rates, economic re-openings and dovish central banks are buttressing a very positive outlook for economies for the second half of this year. With the $1.9 trillion support/stimulus package being implemented, U.S. fiscal policy is on a trajectory to significantly improve 2021/2022 growth globally, not just in the U.S. With a second, infrastructure package also likely to be discussed in the fall, probably worth at least another $1 trillion, the tailwind for the U.S. and global economy is strong, even with an upward trend in yields seen so far this year.

While we do not expect a dramatic sell-off in government bond markets, we think the risk is skewed to yields rising, as valuations are now considerably richer than they were two months’ ago. The recent price action only makes fundamental sense if one believes the neutral policy rate, r*, has shifted considerably lower post-pandemic. While it is possible this has happened, it will take time for it to be proven one way or the other, and we do not see what new data have emerged to cause investors to become bearish about long term growth. The current surge in inflation is expected to be transitory but there is a risk it becomes more persistent due to higher wages and inflation expectations. The fact that real yields remain close to all-time lows suggests financial conditions remain very accommodative.

Emerging Market (EM) Rate/FX

Monthly Review

EM debt returns were mixed in June. Hard currency sovereigns delivered strong returns, predominantly driven by lower U.S. Treasury yields. EM Corporates were also positive for the month, according to the JPM CEMBI Broad Diversified Index, with high yield outperforming investment grade corporates Local currency bonds posted negative returns, due to weaker EM currencies versus the U.S. dollar. From a sectoral perspective, companies in the Transport, Oil & Gas, TMT and Utilities led the market, while those in the Real Estate, Financial, Industrial and Consumer sectors underperformed.

Outlook

We remain generally constructive on EM Fixed Income assets in the weeks ahead on the back of continued stability in UST yields, a steady movement towards reopening in developed markets, and a pickup in vaccination rates in several EM economies.

Credit

Monthly Review

Credit spreads over the month ground tighter in Euro and U.S. IG. Credit markets also benefitted from slightly higher equities and lower volatility in the month. Curves flattened as long-dated paper outperformed. Supply picked up in the month ahead of the summer with $24.0bn in Corporates and $30.0bn in Financials (of which $10bn was in REITs) taking gross issuance YTD to $327bn.¹

Market Outlook

We remain constructive on credit, and see the asset class supported by a few key factors. Firstly, there remains expectations of an economic rebound in 2021. This will be facilitated by continued positive support from monetary and fiscal policy as rates stay accommodative and QE creates strong demand. We expect corporates to maintain conservative strategies until the real economy normalises. Finally, we expect continued demand for credit in general, if risk-free assets continue to offer negative real and absolute yields.

Securitized Products

Monthly Review

June experienced active new issuance, quiet secondary trading activity and relatively low market volatility. Interest rates remained largely range-bound, and the curve flattened meaningfully as expectations of potential Fed rate hikes were pulled forward.

Outlook

Credit fundamentals remain strong in the residential and consumer sectors of the securitized markets, while commercial real estate continues to face some remaining pandemic-induced stress. We continue to have a positive outlook on residential and consumer credit sectors and a more cautious view on commercial mortgage backed securities (CMBS).

¹ Source: Bloomberg, as of June 30, 2021

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