CreditSights strategist: investors are underpaid for risk. What’s the problem?

There is "too much money" in the US market, and together with AI optimism this is masking a deteriorating economic backdrop and rising risks for fixed‑income investors. This is the view of Zachary Griffiths, CFA, Head of Investment‑Grade Credit and Macro Strategy at CreditSights (Fitch Group), who shared his perspective in an interview for Oninvest.

— Despite the prospect of slower global growth, rising inflation risks and the war in the Middle East, financial markets have remained relatively calm. In your view, do current government bond yields and credit spreads adequately reflect what is happening, or is it already time for investors to reassess the picture?

— The most clearly mispriced part of the market right now is credit spreads, in our view. Typically, when we think about some of these major global risks or big policy shifts we have seen over the past year and a half – tariffs, the war in Iran – you would expect higher compensation for risk, both in equities and in credit. That really has not happened.

Today, US investment‑grade corporate bond spreads versus Treasuries of comparable maturity are around 80 basis points, if not tighter, and US high‑yield spreads are somewhere around 265 basis points by our estimates. That is a very low level of compensation for credit risk.

The more visible adjustment has actually been in government bonds across the globe. We have seen a pretty substantial sell‑off in sovereign debt, and that is being reflected in what has historically been seen as one of the least risky asset classes – developed‑market government bonds. At the same time, many credit investors are really all‑in‑yield investors as well. So while they are not being paid much of a premium for taking credit risk, all‑in yields still look quite attractive in a historical context.

When we talk to clients, we hear a lot of demand for high‑quality fixed income at these all‑in yield levels, even though valuations look rich if you focus purely on credit spreads. So we are more worried about the slow‑growth backdrop and a weaker US labor market than what is currently priced into credit spreads.

We are also seeing a fairly substantial sell‑off in global bonds again today, driven mostly by higher real yields in the US. I think that is interesting and probably more related to the risk of policy rates staying higher for longer, and to greater concern about fiscal sustainability and the size of the deficits we are running in the US and across the G10, as well as what the war in Iran may mean for the path of government spending.

So I would almost argue that investors are being inadequately compensated for credit risk and for the risk of a slowdown in economic growth driven by a weaker labor market in the US. Some of the developments that are fuelling greater inflation risk are only exacerbating the growth risk. You can see some of that being priced in through higher breakevens across the curve, and that is something we are watching closely.

Ultimately, in our base case we still think that, at current levels, government bonds will offer an attractive entry point for longer‑term fixed‑income investors. But the move we are seeing today is concerning and points to a possible reassessment of longer‑run risks. A more positive driver of higher real yields in the US is strong earnings, which has probably eased some near‑term growth concerns, and we have had two better‑than‑expected non‑farm payrolls prints in a row. That may be giving markets more confidence in the labor market than we think is warranted.

If you dig into the household survey in the April non‑farm payrolls report, no change in the unrounded unemployment rate figure masks about as large a move as you can have without triggering a change rounded to one-tenth of a percent (to 4.337% from 4.256%) and the labor‑force participation rate fell to 61.8%, the lowest level since late 2021.

Right now there is a lot of comfort with this “low‑hire, low-fire” environment – it has created a somewhat curious balance in the labor market that Chair Powell has referred to. But to us it does not look like the backdrop for strong, sustainable growth.

I think many of those concerns are being offset by AI optimism – the ramp‑up in AI‑related spending and the belief that productivity and efficiency gains are on the horizon and will be a game changer for growth. That is probably a fair assessment over the longer term, but not so much in the near term. It is more of a long‑run story than a 2026 story.

— And what is your baseline outlook from here?

— Our call is for credit spreads to widen in the U.S. to 110 basis points in investment‑grade and roughly 400 basis points in high yield.

We think the market will be forced to reassess credit risk. Spreads will need to move wider to compensate both for the elevated uncertainty and for the deterioration in fundamentals that we expect to see going forward.

In my view, a key catalyst for wider credit spreads would actually be lower US Treasury yields. At the moment, markets seem quite unwilling to price that in, especially with equities still pushing higher. It is relatively rare to see a strong equity rally together with a big rally in Treasuries. In the usual risk‑sentiment framework, falling stocks are good for bonds and vice versa.

At the same time, policy decisions under the Trump administration are bringing inflation risks back to the forefront – tariffs and a global energy shock – even though the stated goal is to improve affordability in the US.

— Would you say that the Federal Reserve is already taking all of this into account in its policy – in the way it communicates, the signals it sends and its concrete actions?

— I think the Fed is in a very difficult spot right now. Kevin Warsh is inheriting what is almost an impossible job. Clearly he has managed to convince President Trump that he is prepared to cut rates, even though his track record going back to the 2010s is extremely hawkish. He was the one who worried most about inflation after the 2008–2009 financial crisis and argued against quantitative easing – at least on the scale at which it ultimately happened.

The perception now is that he has effectively promised President Trump that he will cut interest rates. At the last meeting, however, three FOMC members dissented – not on the rate decision itself, but on the language of the policy statement. To me, the statement did not read as overtly dovish, but that was the agreed upon market perception, and was enough to generate three dissents. At the same time, we have had FOMC members like Stephen Miran openly calling for rate cuts.

Warsh is coming in and taking the place of the most dovish Fed policymaker (Miran), against the backdrop of rising inflation that is largely being driven by an energy‑related supply shock. Monetary policy is not particularly well suited to dealing with those kinds of shocks. In that environment, there is not a strong case for immediate rate cuts.

One of the clearest changes we expect under a Warsh Fed is an effort to reduce the amount of forward guidance – either by having fewer public speeches from Fed officials, or by reforming or even eliminating the Summary of Economic Projections. At some point investors, analysts and the media became obsessed with that document. It has attracted a disproportionate amount of market attention and is no longer as useful as it was in the early 2010s, when rates were stuck at zero and forward guidance was the main tool the Fed had to influence conditions without moving the policy rate.

— Do you see this as a positive or a negative step at this point? Could markets be worried that things are becoming “something shadowy”?

— It is an interesting question. When forward guidance and more explicit projections were introduced, policy rates were at zero and the market kept pricing in hikes. In effect, what the market was pricing in was doing the Fed’s job for it, and the Fed did not want to tighten. If anything, it felt that more easing was warranted, but it did not want to use negative rates and was already doing QE.

From my perspective, the Summary of Economic Projections was a way to push back against that market pricing of hikes when that was not what the Fed intended and not what the economy needed at the time. Now that we are well away from the zero lower bound and policy is better positioned to address two‑sided risks, you can argue that the SEP mainly fuels extra speculation and causes investors to fixate too much on particular words or dots in a way that is counterproductive.

You can also argue that financial‑market volatility has been relatively low, and I think the Fed is quite comfortable with that, all else equal.

We would likely see a short‑term spike in volatility if forward guidance were pared back, but over a longer horizon I think eliminating or reducing it would lower the risk that specific phrases or forecasts are misunderstood or over‑extrapolated. The classic example is the “taper tantrum” in 2013, when Ben Bernanke made some comments about potentially reducing asset purchases, and it caused a huge sell-off in bonds.

In general, for me personally, having markets a bit less fixated on every word of the statement or on each dot in the SEP makes sense when policy is closer to its long‑run neutral range. It might help investors zoom out and take individual data points more in stride, instead of treating the latest print as a precise forecast for the next 12 months.

— You mentioned AI optimism. Do you think that optimism is excessive, or does it adequately reflect how fast this segment is growing, the scale of investment and so on?

— Personally, and this is broadly our view at CreditSights, I think the AI optimism is a bit overdone.

Back in February, we saw a significant reassessment of software valuations – people started to question the terminal value of some of these businesses. That spilled over into worries in private credit, given how much exposure that market has to software. We had a broad equity correction – the S&P 500 fell on the order of 8–9% from peak to trough early in the year – and Treasury yields moved lower in a more traditional risk‑off fashion, as AI‑related uncertainty became a key driver of markets.

It all got flipped on its head with the advent of the Iran War. It is now quite hard to disentangle how each of these big forces is influencing current pricing. It does feel like we have shifted back toward optimism again: a number of large tech‑related deals have come to market this year and have generally gone quite well.

The Amazon U.S. dollar deal a couple months ago came with fairly significant new issue concessions, and that's something that we had expected to be a more regular feature of the market this year, and investors starting to push back on all of this hyperscalar spent with the lens of questioning how much return on investment in each of these names could possibly get by spending this on my own.

We thought we were beginning to see the first signs of that reassessment, but in subsequent large deals it has been less obvious.

Clearly, there will be winners and losers in this story. It is hard to believe that every company can spend hundreds of billions of dollars a year and all of them generate comfortably above‑cost‑of‑capital returns on that spend.

The result is a very strong technical tailwind for credit markets, despite an incredible amount of headline and geopolitical risk and some very meaningful changes in economic policy since President Trump took office. Historically, such a high level of uncertainty would be a clear negative for risk appetite, but since COVID we really have not seen that sustained pattern in the same way.

A big reason, in my view, is the sheer scale of stimulus that was injected into the system over those years. Even after the Fed and other major central banks moved to quantitative tightening on the monetary side, the fiscal legacy remains. In the US we are still running a budget deficit of around 6% of GDP. That is something that is underappreciated when we ask how long the bull market and elevated risk appetite can persist.

— Which two or three indicators would you recommend individual investors should follow most closely?

— Given that my main focus is the US, I would start with the US labor market. I would watch the unemployment rate in unrounded form, as well as the labor‑force participation rate. If participation continues to fall, that is not really a sign of a healthy labor market – even though that is essentially what most investors are pricing in right now. 

Personally, I also pay close attention to initial jobless claims. That weekly series has been remarkably stable since late 2021, at around 200,000. In the past, rising claims would typically lead to an increase in the unemployment rate. This time around, we have seen the unemployment rate climb by roughly 100 basis points from its trough, while claims have barely moved.

We have also seen an increase in the average duration of unemployment spells. That is another more “in the weeds” indicator I watch to gauge the true health of the labor market, which can look pretty solid if you only glance at the headline numbers.

A second key area is core PCE, the Fed’s preferred inflation gauge. The question there is how shelter and other core services are behaving. We are trying to separate how much of current inflation is being driven by higher energy prices and second‑round effects from energy, and how much reflects broader, more persistent underlying trends.

— In other words, your advice is to focus on more “down‑to‑earth” indicators rather than market charts?

— That is probably fair. It is increasingly hard to separate signals from noise in a very messy policy environment with powerful geopolitical shocks. We essentially have two hot wars going on at the same time. If your goal is to understand the underlying economic trends, it is more useful to stay anchored in fundamentals.

From a personal‑investing perspective – which is not our core business at CreditSights, since we advise institutional clients – I am convinced that it is critically important not to go entirely to cash every time volatility spikes, but to stay invested and ride through it.

One of the main lessons of the 2020s, in my view, is that markets have proven to be significantly more resilient than they were in the 2010s.

In the US context, you also have to think about the sheer amount of liquidity in the financial system. It really feels like we are living with “two economies”. At the lower end of the income distribution, households are facing a higher overall price level and higher borrowing costs.

At the upper end, households are also dealing with higher prices, but many of them locked in very low rates earlier in the 2020s, for example on their mortgages. Their debt burden is effectively fixed in the form of 30‑year fixed‑rate mortgages, while higher interest rates have allowed them to earn more on government‑bond holdings and even on cash.

As a result, financial markets are really a window into only one, more fortunate part of the US economy, while the other part is under significant pressure. We do not yet fully understand how long this set‑up can persist in the context of a slowing US economy.

— Since you mentioned this, are there any indicators that might help you gauge how long this pattern can last?

— It is hard to say with any precision, and it is something I would like to do more work on. If you look at Federal Reserve data on household cash balances by income quintile – including the New York Fed work – you see that the top quintile is doing very well, while at the very bottom, household cash positions – bank deposits and money‑market fund holdings – have been essentially flat in nominal terms since the end of 2019. Over the same period, the overall price level is up by roughly 25%. In real terms, that means their cash has lost about a quarter of its value.

At the same time, we see headlines noting that more than half of consumer spending in the US comes from the top 10% of households by income. Until we see a sustained reversal of the wealth effect that I described earlier, it is hard to argue that a deep, broad‑based economic downturn is just around the corner.

— That is a very interesting point. I have to admit I had not quite thought about it in this way. Do you think this more “down‑to‑earth”, real‑economy approach to investing can be applied to other regions as well, not just the US? For Europe, maybe?

— I think so. In general, I would say Europe is in an even tougher spot than the US – partly because of its energy vulnerabilities, and partly because the fundamental backdrop for growth is weaker.

I should say up front that I live in the US and I am primarily a US‑focused analyst. When I talk about Europe, I tend to oversimplify and treat it a bit like one homogeneous entity, which it obviously is not. But when I speak with our strategist in London, Logan Miller, the picture that emerges is one of slower growth, while in the US a lot of the optimism and realized growth in recent years has been driven by large AI‑related tech names, where the US is at the forefront and Europe is lagging. The innovation engine in Europe looks weaker by comparison.

That is why I think Europe faces an even higher risk of something close to a stagflationary scenario – persistently higher inflation driven by energy pressures without a strong growth backdrop to offset it. On top of that, new US tariffs and European counter‑measures are adding to costs.

— Will the European Central Bank be able to deliver at least two rate hikes this year, as the consensus expects? Or, given the more challenging backdrop, do you think they will end up being less willing to tighten?

— We are sellers of rate hikes in Europe and the UK, so as our analyst, Logan Miller, he is calling for no rate hikes.

We are, in many ways, skeptical of current market pricing and of the idea that such a policy response would be appropriate in this environment.

If a large part of the inflation pressure is coming from the supply side and monetary policy is not well suited to address those drivers directly, then hiking rates mainly hits demand. If demand is already fragile, that increases the risk of a recession – and you may not do much to tackle the original source of inflation.

— Especially given that many of these pressures are external, right?

— Right. In a traditional recession, the economy experiences demand-driven disinflation or even outright deflation in parts of the economy. But if the main driver of inflation is external and beyond the central bank’s control, then that path leads you straight toward a stagflation‑type outcome. Monetary policy puts additional pressure on the demand side while doing nothing to relieve supply-side pressures. That is essentially the worst‑case scenario – both for policymakers and for the economy.

— Thank you very much for this conversation.