Silver linings in a higher-for-longer rates backdrop
President, Fixed Income & Data Services
ICE
Option-adjusted spread (percentage points)
What a difference a few inflation reports make. In the U.S., just one rate cut is being priced in by markets for this year – a projection that remains a moving target – down from 6-7 expected cuts back in January. For fixed income and housing markets, a higher-for-longer backdrop has some key implications.
Across the housing landscape, high rates have prompted a lock-in mentality where many homeowners are understandably reluctant to sacrifice their cheap mortgages from the era of low rates. Yet the housing market remains in robust health: strong home price growth in early 2024 has boosted mortgage-holder equity to a record $16.9 trillion, with 48 million U.S. homeowners having some level of tappable equity, according to ICE Mortgage Technology data.
Mortgage-backed security (MBS) investors also face favorable dynamics: lackluster transaction activity means supply has dropped to multi-year lows and higher-for-longer rates will likely mean a continuation of light supply and muted prepayment activity. From an investment standpoint, this reduces some key concerns around prepayment risk and uncertainty about the direction of rates.
For municipal (muni) bond markets, the inverted yield curve persists – a rare dynamic for the segment, reflecting far higher correlations between Treasuries and munis than we’ve seen historically. Muni issuance remains tepid for a third year running, and while investor demand is strong, higher short-term rates mean munis are increasingly competing with high-interest savings accounts for investor money.
For high-yield bonds, a low default backdrop means the segment looks set to continue its strong performance from last year: the ICE BGlobal High Yield Index has returned 2.08% for the year as of May 31 in U.S. dollar terms, outstripping returns from investment grade debt (the ICE BofA Global Corporate Index shed 1.12% YTD in U.S. dollar terms) as spreads tighten. Interestingly, the average U.S. high-yield spread almost hit its lowest point since 2007 in May, according to ICE data. Similarly for corporate bond issuers, credit spreads approached their lowest levels in almost two decades during May. This has prompted many companies to issue debt rather than risk higher costs in future, especially with the prospect of market volatility around the U.S. presidential election in November.
All up, the backdrop appears rosy. One could reasonably deduce that the Fed has engineered a soft landing. But when I look at the chart below, showing that credit spreads were last this low in 2007 before the financial crisis – a period also marked by a seemingly low-risk backdrop – I can’t help but remain cautious.
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