Bloomberg Real Yield 07/21/23
From New York City. For our viewers worldwide, I'm Katie Greifeld. Bloomberg Real Yield starts right now. Coming up, barreling into a triple header of central bank meetings with inflation cooling around the globe, all as the riskier credits continue to outperform. We begin with the big issue waiting for the Fed. The Fed and their tightening campaign
widely assume they're going to hike in July July at Bake in the Cake higher for a longer hike by 25 basis points. The Fed might need to get a little bit more aggressive here. Inflation data coming down faster. A lot of indication yet of greater labor market weakness.
Consumers showing up in some really welcome news for the Fed as of late. The last inflation print was quite low. Expecting inflation to come down. The economy is going to surprise people by its resilience.
The data is kind of starting to show us that maybe we won't have that recession. What is the wage inflation target for the world we're living in today? How high will they be willing to tolerate? At some point, we do think the recession is going to come. Joining us now, I'm thrilled to say we have PIMCO's Tony Brzezinski and Bank of America's Meghan Swiger joining me on set on a Friday. So must be my lucky week. And we're, of course, meeting before the
Fed meeting next week. And Tony, getting away from the how many more hikes are left. It seems like July is baked in at this point. How long might this Fed be on hold? Well, the view of rate cuts flies in the face of Paul Volcker, the legendary Fed chair, and his idea of keeping at it, of course, the title of a book he had Chair Powell over a year ago said that one of the three lessons of history is to keep at it, to sustain the higher rate of the Fed funds rate in order to keep the pressure on inflation, downward pressure on inflation.
The Fed doesn't want to make the mistakes that have happened historically, which is to have to cut rates prematurely. So you should expect the Fed to keep at it for some time until it's clear. And by clear we mean through inflation expectations that the job is done because the inflation data alone won't cut it.
The Fed has to feel that households are confident that the inflation rate will be down over the long run, too. Mm hmm. And Meghan, Tony brings up Paul Volcker. So let's talk about Ben Bernanke, because we actually heard from the former Fed chair this week. He weighed in on the next move, saying that it looks very clear that the Fed will raise another 25 basis points at its next meeting.
It's possible this increase in July might be the last one. And Meghan, if it's July and Dunn, how does that work itself through the Treasury curve? How are you thinking about opportunities at the short end versus the long end? Sure, Katie. Great question. So what we see borne out in history is that you really want to be buying the last hike of the cycle, particularly further out the curve. So we do think that going long tends, as we're nearing the Fed's final hike, makes a lot of sense. You usually see the ten year rate rally around 100 basis points or so in the 12 months after the Fed's delivered that final hike.
Markets right now are only pricing about a ten basis point rally or so. So we think that those long positions are well served, but important to be putting them further out the curve because when you look at what's priced into the front end and Tony was just making this point earlier, there's a lot of question marks around how long the Fed is going to stay on hold. But the market's pricing a full 25 basis point cut by the first quarter of next year. So we do think that there's more room for the curve to invert further. We like being long, further out, but we do think that ultimately the cuts priced in right now are largely overstated.
And I want to get to the message that the yield curve is sending, but you bring up duration. I'm glad you went there because we actually got the annual investment letter, one of the investment letters from former PIMCO CIO Bill GROSS, and he wrote that with inflation back to 3% or so and the Fed nearing the end of its tightening cycle, it would appear to many that a new bond bull market is about to begin. But while I think that the ten year at 380 may have peaked at 4% for 2023, a bull market is not in the cards. So imagine you've got Bill GROSS on the other side of the trade. Tony, where do you fall? Well, you would say and I would agree with Megan, in fact, 90% of the time since 1978, core bonds, those with duration, let's say, of six and a half years average maturity in the sevens or so have outperformed cash, T-bills and such 9% of the time by an average of three percentage points over a three year rolling period. So looking back three years from now to
today, it's likely that these longer matures will fare well. And so it's a fool's game to some extent to keep playing the T-bill money market game Blink and you may miss the next big bond rally. So the time is now for total return style of investing to get the gains that Megan suggested could occur because of a move of 70 or 80 basis points or so on.
A ten year instrument means a lot in terms of price gains, and you never know when that will happen and for what reason. And so now is the time and has history suggests it when the Fed is about to be done with its rate hike cycle, call it a few months. That's the time to be investing in longer maturities withstand, we would suggest the volatility that that could bring in the interim because you can't time a diversifier as bonds are and so we would suggest being.
Leery about doing so. So it sounds like the opportunity of cost of cash is very real right now. It's speaking over the long term because while it is quite attractive and you do want some liquidity, but you got to be sure that you're getting a return for that liquidity in short term funds such as such as those that we have managed by Jerome Schneider, for example, the carry the yields maturity is in the zone of over 6% or so. But you want to be sure that you can part with the liquidity to get those yields. But we think there's always some for many investors, I should say, ability to part with liquidity to get that extra yield closer to 6%. Mm hmm.
And I do want to get back to the yield curve, because that's really been one of the big stories in the market, that extremely stubborn inversion that we're seeing and what it's actually signaling back and I was reading your notes and this stuck out to me that the deeper curve inversion doesn't necessarily mean that recession risk is higher. Talk to us what you mean by that and what this curve actually is suggesting. Sure. So I think that when we look at recession probability models, for example, write, they largely take into account the shape of the yield curve, the very deep inversion that we're seeing. And if you look at those that would suggest that recession risk is elevated right now, But what the curve inversion is telling us and what the curve tends to get right is anticipating Fed policy action. So the curve inversion is really telling us this message, this expectation for the Fed to be cutting. But the Fed can be cutting for different reasons, right? So in recent cycles, right.
The Fed is cutting alongside the downturn that we saw following the pandemic, its cutting during the global financial crisis, but the Fed can be cutting this time. And what the market's actually reflecting is cuts alongside inflation, moderating very quickly. So certainly we've gotten a lot of good news on this in recent inflation prints. But the market's pricing not only this perfect storm of inflation falling right now, but that continuing over time and the Fed operating at a policy rate as aggressive as they are right now, fight over, you know, 5% after they deliver this, this next hike ultimately will become more restrictive at a lower inflation rate. So it argues for them being able to cut alongside moderating inflation, which we think is really the message that the curve is telling us right now. Not so much these cuts alongside a
material growth downturn. So in a way, just to draw this point out, it sounds like almost what you're saying is that the fact that the curve is this inverted is in some way an endorsement of the Fed's policy. Absolutely. Absolutely. And I would say that the one thing that Powell can look back on and really see a lot of credibility on is the inflation market and five year five year breakevens, which are the Fed's view into how the market's reading these longer term inflation expectations that that Tony mentioned. They have been consistently pricing the Fed, being able to hit that 2% target over the long run, even alongside a lot of volatility in spot inflation. So there's a lot of credibility that the market is giving the Fed right now.
Kitty, I was going to say, and I agree with Megan that it's the confidence in the Federal Reserve that it will keep inflation down to whatever it takes, if you will, that is causing it in part. Secondly, there's what's called the term premium effect, which is the impact of Fed policy in the bond purchases that it made in the past on yields. Consider, for example, the Federal Reserve holds two and a half trillion dollars worth of mortgages. It has $5 trillion worth of treasuries. It took a lot of bonds off the shelves several years ago during the pandemic. So go to those shelves today. There aren't fewer items on those shelves.
So the prices naturally are higher as the Fed puts some of those items back on the shelves. The term premium, the additional yield you get for going out, the yield curve will start to rise. And so that will begin to affect yields. But the biggest factor, I would say, and
agree with me again is the confidence in the Fed a view on future rate cuts in terms of where yields are eventually going. And again, it's another message to investors too, to not wait too long in adding duration to turn into turn toward total return style investing, income, style investing, anything where you can get the capital gain and high quality assets. So there's I mean, five different points that I could dig into there that are interesting. But Megan, you also made the point that it's not just the recession that would cause the Fed to cut. We're in restrictive territory now. I don't think that's controversial to say. And just getting out of restricted territory will require some rate cuts.
So, Tony, I have kind of a difficult question. Where do you think neutral is in this economy? PIMCO view since 2014 is that the neutral rate is somewhere between zero and a half point above the inflation rate. So call it two and a half or so. It may be evolving. There's a debate about the impact of demographics.
For example, we know that 1957 I've mentioned this effect before. Its biggest birth year last century. So that means fast forward 65 plus years later, big wave of retirement, the biggest wave in history, reducing the amount of labor supply. And this will continue through 2030, pushing up wages. And that could have an impact for all we know on the neutral rate. Secondly, there's this movement worldwide to invest in defense and to invest in the brown to green energy, energy transition, etc., supply chains. All of that might might raise spending
and reduce the saving glut that has kept interest rates down can also boost productivity, which can have an influence, an upward influence on the neutral, the neutral rate. So it so the jury's out, but we're sticking with the idea that it's lower than his historical and that'll keep yields low and the yield curve probably reflects that. And we don't have much time left, but I'd be remiss if I didn't mention that it's not just the Fed. Next week, of course, we have the ECB and the DOJ as well. And Meghan, when you look at that line up, where do you think the most risk for surprise comes from? Which region? Which central bank? That's a good question, Katie. You know, I think ultimately the message
that we're hearing across all central banks right now is this commitment to data dependence. So the central banks right now are also pretty limited in terms of how much they can ultimately shock the market, because so much of the path forward here is really going to come down to the data. We're going to hear that from the Fed next week. The story is going to be a lot more about the focus around what they're ultimately going to do next. And at the end of the day, the Fed needs
to be able to push back against some of this easing and financial conditions that we've seen following CPI, that the relatively muted reading that we've recently gotten. So all of those things together do lend itself to central banks needing to keep that expectation out there for potential adjustments higher. And overnight policy rates are a lot to look forward to. This is a great preview, guys. Thank you so much. Our thanks to Meghan Swiger and Tony
CRECENTE. Up next, it's the auction block, big bank earnings driving the week of issuance. That's next. This is really yield on Bloomberg.
I'm Katie Greifeld. This is Bloomberg Real Yield. Time now for the auction block where big bank earnings drove sales. This week. The US high grade primary market saw weekly volume pushed past $30 billion, topping the high end of estimates. Wells Fargo was the main contributor contributor price in two separate deals totaling more than $10 billion. We'll dig deeper into those banks as
they saw some massive demand. Morgan Stanley, JPMorgan and that Wells Fargo sale all saw their order books easily outpace their sales. And investors also piled into the leveraged loan and high yield bond market. Just Monday alone saw eight new loan
deals and four junk bond sales. The week totaled more than $3 billion in high yield. Meanwhile, Gersh and distant folded AllianceBernstein says that the current environment presents a buying opportunity. We think that bonds our bonds are back,
so to speak. Right. Yields now across the spectrum going out and into corporates, emerging market debt and other parts of fixed income, where the total return you're going to see or the potential at least is a lot higher than it's been for most of the past decade. Joining us now. I'm pleased to say we have Maureen O'Connor of Wells Fargo and Zack Griffiths of Credits sites. Great to have you both with the SEC. I want to start with you. Between very bearish and pound the table
bullish, where do you fall on this corporate credit market? I'd say we are bullish and really that's adjusted a bit recently. I think the move in high yield has gone a little bit too far. And so we did recently downgrade high yield to market perform from outperform. And that's not to say that we're moving to a cautious outlook on a high yield, but we are recognizing that the opportunity for spread compression from here is probably limited. Forward returns do look great on a six
month and 12 month basis. And so we do think that's still a good trade, but we recognize that the possibility for additional tightening is probably limited and we also maintain an outperform recommendation on investment grade. We have a spread target of 120 basis points, so are looking for a little bit more tightening there. So definitely in the bullish camp overall.
And Zach, I want to get to that high yield call, but let's talk about investment grade, Maureen, because right now IG spreads are already at 120 basis points, really close to the narrowest levels of this year. How much lower could spreads feasibly go from here? Yeah. So I think we agree with Zack in that our longer term view is bullish across credit products, including investment grade. But I think in the near sense we're probably a little bit more neutral in that We've come very far, very fast.
If you look at the index level, as you note, you know, we are trading very close to the year to date ties only about five basis points wide of the heights we saw back in May, Q1. A lot of the higher quality industrial names are already trading at their year to date heights. So if there is any sector level performance from here, it's probably within financials, perhaps further down the rating spectrum with some further spread compression across triple B's. But as a whole, it does feel like in the near term sense, spreads are pretty fully valued in this current range.
And we see a little bit maybe more downside risk to spreads over the next couple of months versus upside potential. And let's talk about that narrowness that we've seen. It's come with really very little volatility. There was a really interesting report out from Barclays, I believe, looking at the past three weeks, stacked high grade spreads have traded within a range of just three basis points. That is the narrowest band in 18 months.
And given that we're already at your year end target for investment grade spreads, what kind of volatility do you expect from here or could we just continue to grind sideways? I think running sideways is a possibility and the lack of volatility we've seen, I think comes to interest rate volatility coming down quite a bit, at least at an aggregate level, looking across the curve. And you've also had limited volatility in equities and effects. And so I think financial markets are coming around to the view that at least the Fed is almost done tightening. We are expecting a 25 basis point rate hike next week and for the Fed to remain on hold for the remainder of the year. So I think a lot of the macro volatility that we've gotten used to over the past year and a half is starting to subside.
That's a positive for spreads. And so in terms of additional tightening, perhaps it's limited, but with yields at these levels, we think it's an attractive prospect and is likely to bring a tailwind of technical demand in the second half of this year. Let's talk about that technical demand, because even with this conversation that we're having about a rangebound market spreads fully valued, it's an important point that there's still a lot of demand out there. And Maureen, in your notes, you point out that if you look at the fund flows, people are clearly coming into that asset class, break down the demand. What types of buyers are emerging here?
Yeah, you know, we're in sort of a bit of a sweet spot in that we've seen a return of the total rate of return buyer. So this is different than last year where we had, you know, record breaking outflows across high grade ETFs and mutual funds. That dynamic has almost reversed itself this year. We've had nearly unbroken inflows every single week into high grade funds this year, with the exception of a couple of weeks right around the regional bank crisis in March, we've raised almost 80% of the full year outflows we saw in 2022 to this point. So you have a return of total rate of
return buyers chasing what's been about a three and a half percent returning year for the asset class. But then on top of that, and as was noted, you know, with yields remaining elevated like they are, we still have a very attractive entry point for our more yield focused buyers. So pension funds, insurance companies, LDI buyers yields are still trading about 150 basis points above outstanding coupons on the index. So you have this perfect storm of, you know, a number of different buyers chasing investment grade. All the while, supply has been pretty
moderate. This year, we're down about 3% versus last year's volume. So that technical has been quite strong. And so that's the investment grade backdrop.
A lot of demand there. I want to talk a little bit more about the high yield side of things because we heard from Amanda Lyneham over at BlackRock earlier this week, earlier this week saying that there could be weakness ahead in those riskier credits. There's probably some scope for resilience still at the high end of the high yield spectrum. We don't view a recession as a necessary ingredient for an uptick in defaults.
And Zach, like you mentioned earlier in this interview, you recently downgraded the high yield market to market weight from overweight earlier this month. Where do you see as the fundamental backdrop when it comes to some of these junk traded companies out there? I think you're really, Katy, seeing a bifurcation in terms of the lowest rated credits, really showing signs of deterioration in fundamentals. And so triple C's have performed very well so far this year, but we'd really emphasize very focused credit and security selection if you're going to go very far down the credit spectrum.
If you remain up in triple B's or double B's, excuse me, that's certainly a very attractive place in terms of yield. And we haven't seen the deterioration in credit fundamentals. You're seeing a softening there, but we think it's really manageable at this point in terms of other factors in the economy, including plenty of cash on company's balance sheets, providing some financial flexibility even as borrowing costs rise.
We're really not looking for the maturity wall to hit until 2025. And so if yields and rates are still at five and a half or 6% in terms of the policy rate going into the second half of 2024, that could really become an issue. But that's not our base case. And so we think that, you know, high yield is still a great place to be, but you need to be careful with your rating selection. And Maryn, we don't have much time left, but I want to get your thought on the second part of what Amanda Lyneham said. That we don't view a recession is a necessary ingredient for an uptick in divorce. When you think about this demand that we've seen for investment grade.
Would a recession scare away some away some of those buyers? I mean, yes and no. Right? I mean, what you'll see is ratings decompression, right? You're going to see investors gravitate towards the highest quality names up the stack, single-A rated names, and you'll see Triple B's underperform in that environment. But remember, our market is driven a lot by base rates, right? And so in a recessionary environment, Treasury yields are likely to rally and that rally will generate positive returns in fixed income. And those returns will attract those total rate of return buyers. To the extent the losses that you see on the spread widening, don't overcompensate for that move lowering rates and that tends not to be the case. So said another way, we would still
expect to see investors buying investment grade as a as a safe haven play and also place where you could still potentially eke out some positive returns even in a recessionary environment. All right. Maureen and Zach, got to leave it there. Really appreciate your time. And a reminder that right now, Biden, President Biden is now speaking following a meeting with seven leading artificial intelligence firms about a new agreement for AI safeguards. You can check that out at live. Go on your terminal. This is Bloomberg.
I'm Katie Greifeld. This is Bloomberg Real Yield. Time now for the final spread, the week ahead. Coming up, we have the Nasdaq rebalancing monday, tuesday, tech earnings Wednesday. It's the Fed's rate decision. Then we have the ECB on Thursday and Friday. It's the DOJ global central banks, the one to keep an eye on. From New York, this is Bloomberg.