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Fixed Income Monthly - October 2022

Introduction

Central banks continue tightening monetary policy to double down on inflationary pressures. In the case of the US Federal Reserve (Fed), the Bank increased the Federal Funds Rate to a 3% to 3.25% range (up 75bps) at its September meeting, in-line with consensus expectations. As expected, the European Central Bank (ECB) also hiked interest rates to 1.25bps (up 75bps), coupled with a significant upward revision to its inflation outlook.

However, if central banks remain excessively hawkish and over-tighten monetary conditions through a mix of interest rate hikes and quantitative tightening (QT), there is a risk of an inflationary bust, with economies unable to mitigate the risk of a heavy global recession. In September, the Fed’s QT programme ramped up to its maximum level, moving to a new cap of $95 billion per month from $47.5 billion. Some investors are worried that this extra monetary tightening could hurt both the economy and assets prices.

Nevertheless, the high risk of a hard landing makes US and core Europe duration relatively attractive on expectations that in the long run central banks will eventually have to pivot and cut interest rates as inflationary pressures ease and the growth picture continues to deteriorate.

In the US, the prospect of the Fed pivoting has been pushed out to at least March 2023, amid a terminal rate of around 4.6%. However, pricing pressures continue to moderate with the five-year breakeven inflation rate falling to 2.14% at month end, its lowest point since June 2021. Such actions should, in the long run, make the Fed less inclined to carry out impulsive interest-rate rises, which could be a market stabiliser. For Europe, the market continues to project rate hikes into year-end and well into 2023 but we believe this steep hiking path will be hard to implement in practice.

In the near term it is time to remain highly selective. We remain defensive, with continuing exposure to investment grade bonds, where valuations remain relatively attractive. Were the US to head into recession, credit defaults would rise significantly. Yet, the market is yet to reflect these risks, notably in high yield credit. According to our analysis, market implied default rates for the high yield segment currently stands at just 2.7% in the US - roughly what might be expected in a very shallow recession. By contrast, realised defaults peaked at around 14% during the global financial crisis, according to Bank of America Merrill Lynch, with a market implied default rate of above 12%. Prudent credit selection within high yield is therefore essential.

Steve Ellis
Global CIO Fixed Income

The Fixed Income Monthly provides a forward-looking summary of the medium-term views from the Fidelity Fixed Income team.

Strategy summary
Summary of returns as of 30 September 2022 (%)
Macro and Rates Overview
Inflation-Linked Bonds
Investment grade credit
High yield
Emerging markets
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