Steve Ellis, Global CIO Fixed Income, Fidelity International, discusses how as the market narrative continues to evolve, the diversifying effects of duration are becoming more prominent.
Usually, when economic stress occurs and credit spreads rise, expectations of easier monetary conditions boost duration; however, we have seen both duration and credit spreads selling off simultaneously this year as investors priced in higher interest rates at the expense of growth.
With an aggressive rate hiking cycle factored into bond markets, value is emerging in duration, at last, and we expect it to become a diversifier for credit risk once again.
We do not believe that central banks will be able to raise rates to the extent that they or the market forecasts given the headwinds to already moderating economic growth.
Following an unprecedented Fed’s balance sheet expansion – more than doubling over the pandemic period from US$3.9 trillion in March 2020 to US$8.5 trillion in May 2022 – the reduction plans are aggressive and will significantly tighten financial conditions, causing damage to credit markets.
The Fed intends to work towards a monthly balance sheet run off target of $95 billion later this year, but if the impact on markets and the economy is too great, it will be forced to re-think its strategy. A similar scenario could develop in Europe, especially given rising risk of severe gas disruption. As a result, we have been adding to duration in Treasuries and European sovereigns.
This rising risk of recession is also not fully reflected in credit spreads. Spreads have widened, but investors are not being compensated for a recession scenario.
Our calculations indicate that the US high yield market is pricing in a one-year default rate of around 2.7%. This is meaningfully higher than only a few months ago, but still significantly below what we normally see during recessions, for example 7.5% in 2020, 7.5% in 2016 and 12.5% in 2008. This is translating into negative credit risk premia in high yield and pockets of positive risk premia in investment grade, supporting more defensive positioning.
