The balanced approach to income generation for fixed income has certainly been under challenge. If we look at five-year yields—early September, 180 basis points; today they’re at about 2.8%. So, 100 basis points higher means you’re going to put price pressure on a balanced approach to generating income.
The US data, for most of this year, has been rather robust. Which has encouraged the Federal Reserve to continue to raise interest rates. The Fed has raised interest rates now eight times since the end of 2015. And the more the Fed has to raise rates, in the minds of investors, the more challeng[ing] it becomes for a balanced approach to generating income.
I think there’s at least four good reasons as to why the balanced approach to income generation certainly makes sense. Valuations are much better—reason number one. Five-year yields being 100 to 120 basis points higher over the last 15 months means that your return expectations have dramatically improved.
Reason two: volatility has just come back to broad capital markets, like long-term averages. Investors were reminded why a balanced approach, including Treasuries, makes sense to deliver a smoother ride to income generation.
[The] third reason is that growth expectations today and looking forward have been reduced, both globally and in the US. We’re looking at interest-rate-sensitive sectors, specifically housing and autos. And we’ve seen a slowdown…not enough for the Fed to completely stop raising rates, but those are the first sectors that are probably going to be impacted with prior Fed rate hikes.
Another reason the balanced approach to income generation makes sense in our mind is that we’ve seen this before. Historically, the Federal Reserve has raised interest rates to the point where something in either the real economy or the financial economy has broken. And when it breaks, usually we see high-yield spreads widen meaningfully. When they mean-revert, they typically mean-revert very quickly. And that’s when in a flat US Treasury yield curve, investors are reminded why they own US Treasuries in the first place.
Investors, I think, are a little bit more comfortable now that the Fed isn’t going to likely raise rates as much as investors were worried about two months ago. Now is a good time to be patient. Now is not the time to panic. I think investors, post the global financial crisis, have forgotten what volatility looks like. Central banks, especially the Fed, [are] in the process of both raising overnight funding rates and reducing the size of the balance sheet. That’s new. That’s unprecedented. That makes investors nervous. But when you look at the underlying drivers of the economy, we’re still in pretty reasonable shape here.