What’s Driving Bond Markets Today?

Yield is back in the bond markets – after years of historically low to zero interest rates around the globe. Just how long can we expect higher rates to last? Could a recession cause volatility? Where should fixed income investors be looking for attractive yield opportunities today?

To gain firsthand insight, Investment Strategist Erica Casale sat down with Loomis, Sayles & Company’s Peter Palfrey, Co-Manager of Core Plus Bond strategies. He shares his team’s views on where rates may go from here, inflation, the health of the US and global economy, and what sectors of fixed income may be offering diversification and alpha potential.

Here are highlights from the late January 2023 interview:

What is the Likely Path of the Fed, and Inflation?
Well, the peak for the fed funds rate is expected to be around 5%. We think that is a fair evaluation of where the Federal Reserve (Fed) will end up following further hikes. From there, the Fed might be able to step back and take a look around and see what damage it may have generated. But also, they will be looking to see whether inflationary pressures are continuing to moderate. We did peak in the inflation outlook during the fourth quarter of 2022. Headline inflation, as measured by Consumer Price Index (CPI), peaked at something north of 9%. Now we’re at around a 7% level.

Is the US Heading into a Recession?
We think the US is likely to bounce around somewhere near zero real growth for a quarter or two. And that’s going to lead to an increase in the unemployment rate, which is presently at very low levels of 3.5%. Maybe we see 4.5% to 4.8% unemployment. But we don’t think it’s likely to see the damage that we’ve seen in prior downturns. Also, excess savings and the health of the consumer balance sheet is quite good. So we think that the damage that’s going to occur is going to be more limited. And it should provide a better backdrop for growth prospects [in the] second half of this year.

Are there Macro Issues that have Changed Your View of the Credit Cycle?
We still believe we’re in the late stages of the expansion phase of the credit cycle. As we have seen in recent history, the expansion phase of the credit cycle can be as short as a year or two. But it’s rarely that short. Or it can be as long as seven or eight years, which it was back in the period just prior to the pandemic. So it can be a variable amount of time, but the important thing is what happens next. And we do feel that we’re likely to see a downturn in the next six to nine months. We think that it doesn’t have to be a severe downturn, but it probably will be softer growth. And that has to get reflected into corporate valuations, unemployment rates, and the health of the consumer.

Your Team Uses “Plus Sectors” to Add Diversification and Alpha Potential. What Sectors are Standing Out?
Well, we’ve really brought the Plus sector allocation down. It’s been a great diversifier over the past few years. After coming under pressure, the high yield space did well in the second half of 2022. It was a good way to continue to earn incremental carry in portfolios and excess yield. This year, however, valuations seem pretty full.

Another important Plus sector is emerging markets (EM). We continue to like higher-yielding, more defensive corporate emerging markets. On the sovereign side, there are select regions that we think still offer some opportunity. There’s still a price concession that investors get for going down in liquidity into emerging markets. So there could be opportunities in EM, but it’s very regional – and dependent on who their trading partners are. In general, we think Latin America still looks attractive.