2nd Quarter 2023 Fixed Income Review
- Despite a rising Fed Funds rate and “hawkish” rhetoric from members of the Federal Open Market Committee (the FOMC) most fixed income sectors have experienced positive performance year-to-date
- The FOMC hiked its Fed Funds target range 25 basis points in May to 5.00% to 5.25% but “paused” at the most recent meeting in June
- After 10 consecutive Fed Funds rate increases, Fed officials paused in June, but they signaled that 2 more 25 basis point hikes may be needed before year-end to curb demand
- Economic readings show a mixed picture with some consumer and most labor readings healthy, but manufacturing continues to signal contraction
- The core rate of inflation has declined, but still is much higher than the Federal Reserve’s stated target near 2% (the Federal Reserve’s preferred measure of inflation was 4.60% at the end of May)
Below are select Bloomberg fixed income index returns for Q2 2023 and year-to-date:
A significant flight to quality rally in longer dated US Treasuries following high-profile bank failures in March and April, fizzled at the end of Q2 as inflation and employment measures remained stubbornly resilient. The focus upon reserve adequacy, possible enhancements to regulatory oversight, and profitability at smaller “regional” US banks continues to create headlines and garner political debate. As regional banks become more defensive, most economists anticipate the commensurate withdrawal of credit will serve as a headwind for certain sectors of the economy- commercial real estate (CRE) in particular. The clear winners in all of this are large US banks.
Year-to-date, yields on the 2-year US Treasury Note (UST), 5-year UST, and the 10-year UST increased 45, 12, and -6 basis points, respectively, from the end of 2022. Interest rates continue to be quite volatile in 2023 with the 10-year UST yield ranging from a high of 4.06% in early March to a low of 3.31% in early April. The yield on the bellwether 10-year UST was 3.82% at the end of June. The UST yield curve remains “inverted”, with shorter term yields higher than longer term yields, a condition which has historically preceded a recession.
Interestingly, and counterintuitively, yield spreads on lower credit quality sectors have not currently adjusted, using historic measures, for an economic slowdown and continued to outperform investment grade fixed income during the second quarter.
Like the United States, major developed market sovereign yields are generally higher year-to-date as foreign central banks were also hiking borrowing rates to fight inflation. Note the 3-month change in the far-right column. Below are foreign 10-year yields as of 6/30/23. The 10-year UST remains one of the highest yielding bonds in the developed world. The British ten-year “Gilt” yield has increased materially in recent months as the United Kingdom continues to grapple with some of the highest inflation in the developed world.
Hitting the Pause Button
To paraphrase FOMC Chairman Jerome Powell in his most recent post-meeting press conference, when considering monetary policy actions during the current cycle, there were three key issues- the speed of tightening, how high the Fed Funds rate would have to go, and how long it would need to stay at that level.
In hindsight, the Fed’s reaction to burgeoning inflation was too slow, exacerbating the need to speedily achieve a Fed Funds level that was considered sufficiently restrictive to reduce consumer demand and work inflation back towards their stated 2% goal. As the tightening cycle began in March of last year, large 75 basis point rate hikes were initially implemented as a strong signal of FOMC resolve. The pace then slowed to 50 basis points and was followed by 25 basis point increases at meetings earlier this year. At the conclusion of their most recent meeting in June, Fed Chair Powell announced that the FOMC would be “hitting the pause button,” holding the Fed Funds range steady at 5.00-5.25%. He was also very clear, however, this “pause” did not mean the Committee had reached the peak of the hiking cycle. Rather, it represented a further moderation of the pace of rate increases, giving the Fed additional time to analyze incoming economic data and the lagged effects of previous hikes.
The most recent FOMC “dot plot” chart within the June Statement of Economic Projections circulated following the June meeting indicated FOMC members, on average, now expect that two additional 25 basis point rate hikes will be necessary in 2023. Such actions would increase the Fed Funds range to 5.50-5.75% by the end of the year. Interestingly, 5.50-5.75% was projected to be the peak of the tightening cycle back in early March prior to the collapse of Silicon Valley and Signature Banks and resulting widespread regional banking sector turmoil.
Market expectations of future Fed activity have varied wildly over the recent quarter- at times diverging from FOMC projections by up to 100 basis points (a full percentage point). For the time being, the FOMC appears to have successfully conveyed that rate cuts are not on the table in 2023. Bond futures markets have adjusted accordingly.
There are numerous glaring disconnects in the current economic outlook. Service sector employment numbers continue to indicate steady demand while it’s fairly clear that manufacturing is currently in a recession. Although leadership is relatively narrow, broader equity markets have recovered significantly from their lows of last year yet a pronounced inversion of the US Treasury yield curve points to an impending economic downturn. Recently revised GDP numbers from the first quarter indicate steady economic growth but inflation trends do appear to be slowly waning. Compelling arguments can be made for either a relatively severe recession or a “soft landing” in the US economy, and many of our best economic research sources are at odds with each other.
We continue to believe the FOMC is at or very near its current cycle peak in the Fed Funds rate although it may keep overnight rates at these levels for a considerable period of time to allow for restrictive measures to work their way through the economy. The recent flight to quality move in longer dated US Treasuries in March and April has moderated in a material fashion in recent days. Having missed a very short window of opportunity prior to the onset of the regional banking crisis in early March we will be watching for opportunities to moderately extend duration to a more “neutral” bias in high quality fixed income sectors such as corporate credits, tax-exempts, and private credit in the months to come. In addition, although sources of significant recent outperformance, we continue to monitor our riskier allocations, such as high yield and bank loans, for signs of possible stress.
With a broad divergence of economic perspectives and ongoing questions regarding liquidity in some sectors, volatility in fixed income continues to be quite pronounced. That said, more “normalized” interest rates resulting from the recent FOMC campaign to combat inflation have given fixed income investors the best cash flows available in almost fifteen years. It’s hard to argue with money markets and T-Bills paying at, or in excess, of 5.00%, but we recommend opportunistically adding to higher quality fixed income allocations to provide diversification, cash flow, more predictable long-term performance, and a significant volatility offset for riskier portions of our client portfolios. We hope you will consult with your portfolio manager or contact any member of our fixed income team to discuss our thoughts further.
Not Investment Advice or an Offer | This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parentcompany of Argent Trust, Heritage Trust and AmeriTrust.
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