May 2022 Credit Market Update:
Clear and Convincing Data
Economic uncertainty was the theme in May. The Federal Reserve enacted the long-anticipated 50 basis point rate hike, and telegraphed future 50 basis point increases. Chairman Powell’s mid-month remarks indicated that the Fed considers growth to be positive, but that it would need to see “clear and convincing evidence that inflation pressures are abating and prices are coming down.” Powell did not explicitly rule out a 75 basis point hike at some future point, which market participants overreacted to somewhat.
A slight decrease in headline CPI did not lessen market fears that the Fed would tighten too much, leading to a recession. Consumers appear to be feeling the same uncertainty, with the University of Michigan consumer sentiment index declining to 58.4, a cycle-low reading reflecting elevated borrowing costs and rising pricing for both goods and services.
The National Association for Business Economics reported a lower projection for GDP during the month. The median forecast for inflation-adjusted gross domestic product (real GDP) for the fourth quarter (Q4) of 2022 is an increase of 1.8% from Q4 2021, compared to a median forecast of 2.9% in the February 2022 survey. The survey also addressed respondents’ outlook on recession. More than half (53%) of respondents assign a more than 25% probability of a recession occurring within the next 12 months. Recession in the second half of 2023 is seen by 27% of panelists, while 25% expect a recession either by the end of this year or in the first half of next year.
In the latter part of the month, the Fed’s indications that it will follow the data and maintain flexibility led to some reassurance that after two rate hikes, the Fed would take the opportunity to reassess if inflation is trending down.
How Did the Bond Markets React?
After increasing for the first four months of the year, the 10-year U.S. Treasury yield saw its first decline in May, down 9 basis points as fears of a recession drove investors to safer assets. The Bloomberg U.S. Aggregate Bond Index finally made it into the positive column, with a return of 0.64%. It’s still negative for the year, down (8.92%). With the exceptions of emerging market debt and Treasury Inflation Protected Securities, most bond sectors saw positive returns. However, returns remain negative year-to-date, with most sectors having a lot of performance to recover after the rout of the first four months of the year.
A Closer Look: The Fed’s Path Gets Narrower
The spike in headline CPI from a 0.3% increase in April to a 1% increase in May was the largest since 1981. At the June FOMC meeting, The Federal Reserve raised the key short-term interest rate by 75 basis points, for the first time since 1994. The June increase will likely be followed by either a 50 or 75 basis point increase in July and another increase in September.
Besides the upward spike in CPI, among the data that the Fed looks at is the expectations for inflation going forward. Inflation tends to be a self-fulfilling prophecy, where consumer expectations for inflation in the future result in higher inflation.
The most recent University of Michigan consumer sentiment survey said that the public’s expectation of inflation five years from now jumped to a reading of 3.3% from 3% in May. That was the first increase since January. Expected inflation a year from now also ticked up, hitting 5.4% versus 5.3%.
Will the moves work on inflation? Or will we end up in recession or stagflation? The Fed does have a strategy:
- The labor market currently appears to be very strong, and is supporting the economy
- The key short-term rate is currently at 1 ½ to 1 ¾ % — for inflation to get to 2% (from 8.6%) the key rate needs to be closer to 3%.
- Moving rates dramatically now will give the Fed room to cut back if the economy begins to sputter in 2023
In the Summary of Economic Projections, the Fed indicated an unemployment rate of 4.1% by 2024. Powell acknowledged the increase in his remarks, but stated that the number is historically low, and that achieving the joint goals of low unemployment and inflation on a downward path to 2% would be a “successful outcome.”
Performance Among Credit Indices
Source: Bloomberg as of 6/2/2022
Chart Spotlight: Diversifying on the Income Side
With traditional fixed income struggling and remaining positively correlated to the equity markets, the potential for portfolio volatility has increased. A look at how different income asset classes correlate to the Bloomberg Global Aggregate Bond Index provides some insight.
Correlation to Bloomberg Global Aggregate Bond Index
Note: As of March 31, 2022. (1) ICE BofA US Corporate Index (2) ICE BofA Current 10-Year U.S. Treasury Index (3) ICE BofA U.S. High Yield Index (4) Credit Suisse Leveraged Loan Index (5) JPM CLOIE BBB Post-Global Financial Crisis. (6) JPM CLOIE BB Post-Global Financial Crisis. (7) Cliffwater Direct Lending Index
Credit Asset Classes
Other Related Asset Classes