June Outlook
June 22, 2023  |  By Hank Cunningham

Interest rates and bond yields are likely headed higher, despite some deterioration in global growth prospects and moderation in inflation. The IMF is still forecasting positive growth this year. Recession forecasts are growing, and some are concerned about a bout of credit contraction.

Nevertheless, it would be optimistic to think that the U.S. Federal Reserve Board will lower the Fed Funds Rate any time soon. The Fed has paused as it considers the cumulative effects of its tightening to date and will be more keenly attentive to economic data. Chair Powell did say that there is a strong possibility of two more 25-basis-point hikes in the Fed Funds Rate, thus dashing the hopes of those who believed the Fed would lower rates this year.

The possibility of a serious credit contraction would change this outlook materially. In the meantime, corporate bond markets, both investment grade and high yield, have been well behaved, even narrowing in yield from Government bonds. To be sure, cracks are showing in the taut labour market, consumer confidence is ebbing and manufacturing has weakened significantly. However, there are few signs of global inflation subsiding sufficiently to allow central banks to contemplate easing monetary policy. For inflation to even reach 3% seems optimistic. With two-year and 10-year Treasurys seemingly anchored at 4.75% and 3.75% respectively, there is little room for these bond yields to decline.

Thus, central banks will likely retain their restrictive stances for the balance of the year. Inflation will remain the overriding concern and with some recent setbacks in core inflation, both in North America and overseas, it is possible that bond yields will move higher. However, it is more likely that the 10-year yield will fluctuate in a range centered around 3.75%, as it has for a while.

Consumer confidence has been dealt a huge blow, which may contribute to a meaningful near-term contraction in economic activity. Already, retail sales have markedly declined. Fed tightening over the past 16 months is working its way through the system and the recent liquidity calamity is evidence that it is straining the U.S. economy. The market must also deal with the $2.1 trillion dollar budget deficit. Combined with quantitative tightening (QT) to the tune of $95 billion per month, this portends higher bond yields. Despite optimism among pundits, there are no signs that the Fed will begin to lower its key interest rate this year. Whenever this tightening cycle ends, the Fed will likely also end its QT program.

The yield curve has inverted further, following the latest FOMC deliberations, with the spread between two- and 10-year Treasurys approaching negative 100 basis points. In the meantime, fixed income investors are facing only modest returns this year after last year’s record poor performance.

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