Fundamentals

Market volatility has remained high, as concerns over the US banking crisis have spilled into Europe, and as the impact of aggressive policy rate hikes from central banks have become clearer. This volatility is in stark contrast to the start of the year, when markets were lifted by a string of strong data surprises that appeared to push the risk of a recession into 2024. However, the repercussions of Silicon Valley Bank’s collapse have sparked a reversal in market sentiment. Although the market facilities introduced by the Federal Reserve and the US government should, in theory, calm markets, investors should not expect a quick return to where we were before. Not least because the banks would be expected to strengthen their balance sheets in reaction to recent events. As banks de-risk, it is likely that we will see a drop in lending activity, which could ultimately lead to a further tightening of credit conditions and bring forward a recession.

Quantitative valuations

Spread widening on the back of recent market volatility saw US IG spreads reach a peak of 164 basis points (bps) on 16 March, which is the widest we’ve since since 21 October 2022. At the same time, developed market government bond yields provided protection, with US 10-year Treasury yields rallying 51bps from 28 February to 3.40% on 17 March. Interestingly, for the time being, the panic appears to have abated and spreads have retraced around 30%-40% from their recent highs. As of 21 March, US IG credit spreads were at 145bps. At this level, we find that spreads are pricing in a 33% chance of a recession in the US. That said, if we see a material tightening in credit conditions, we’d expect to see spreads widen further as the markets move to price in a recession sooner rather than later.

US investment grade credit spreads are only pricing in a 33% chance of recession

Source: Bloomberg, J.P. Morgan Asset Management; data as of 22 March 2023.

Technicals

The technical backdrop for high quality bonds has recently been positive. Risk-off sentiment has pushed investors into high quality government bonds and money market mutual funds. US and European government bond funds and exchange-traded funds have received over USD 18 billion of inflows month to date (as of 21 March 2023). Furthermore, recent investor positioning surveys show investors are adding duration across developed markets. As credit conditions tighten and the probability of a recession increases, we’d expect to see further moves into fixed income as investors look to add duration.

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