Rethinking Fixed Income

The massive tightening of financial conditions since late 2021 has produced a fixed income market vastly different from the stimulus-fueled environment during and following the pandemic. The cross currents generated by these changes will challenge investors again in 2024.

Heading into the year, we think the best way to describe the macro environment is that we have reached or passed peak everything—inflation, liquidity, fiscal support, China growth, housing, credit availability, and labor market strength. In other words, most of the one-off tailwinds that defined the post-pandemic environment are fading away.

Although global economies—the U.S. economy in particular—have held up relatively well so far despite higher rates, a hard economic landing is not out of the question, especially following the spike in bond yields. Even if a recession is avoided in 2024, we are likely to see economic growth concerns intermittently elevated.

As of late November, futures markets were pricing in four Fed rate cuts in 2024, anticipating that the U.S. central bank would ride to the rescue if the U.S. economy fell into recession. However, we believe the failure of the Fed and most other developed market central banks to get ahead of inflation following the pandemic makes them more likely to hold policy rates at relatively high levels through much of 2024.

Structural forces such as deglobalization, lower labor force participation rates, and energy price pressures also could make inflation stickier than in past economic slowdowns, further discouraging central banks from easing monetary policy.

Of course, a major episode of financial volatility could prompt monetary policymakers to look beyond stubborn inflation and cut rates or pause quantitative tightening—the contraction in central bank liquidity as bonds purchased in pandemic stimulus efforts are allowed to run off their balance sheets.

Potential “canaries in the coal mine” warning of such a correction might include a more severe banking crisis, a collapse in commercial real estate, a significant selloff of the mega-cap tech stocks that led U.S. equity markets higher in 2023, or deteriorating conditions in the private equity markets.

However, our base-case outlook is that central banks will remain on hold for an extended period in 2024. This stance is likely to shift volatility to the longer end of the yield curve, as opposed to the exaggerated upward moves in shorter-term rates seen as the Fed tightened in 2022 and early 2023.

With fiscal deficits ballooning, we expect governments to continue flooding the market with new sovereign debt. This is particularly true in the U.S., where the Treasury is shifting the bulk of new issuance away from short-term bills and into longer-term notes and bonds (Figure 4).

This issuance shift is the basis for one of our highest-conviction calls: that yield curves will steepen in 2024. Although yields on high-quality sovereign debt may have peaked in late 2023, they could still move higher. Accordingly, we think curve steepening is likely to be a more significant factor than the outlook for interest-rate levels.

Another implication of the surge in government bond issuance is that it could crowd corporate borrowers out of the market—or at least force up their funding costs. This could make companies less likely to spend on capital projects or hire more employees, reducing support for the global economy.

Looking more closely at the corporate bond market, attractive yields should continue to support demand for high yield bonds, even though credit spreads—the yield differences between private credits and high-quality government bonds of similar maturity—appear less compelling, trending near historical averages as of late November.

Obtaining attractive yields doesn’t require investors to accept as much credit risk as in the past because the quality of the high yield bond universe overall has improved (Figure 5).