1st Quarter 2023 Fixed Income Review
• Following a tough 2022, most fixed income sectors experienced positive performance in the first quarter
• The FOMC raised interest rates at both meetings during the first quarter leaving Fed Funds at the current 4.75%to 5.00% at quarter-end and foreshadowing no rate cuts for the remainder of 2023
• Banking issues in March spawned a pronounced flight to quality rally in US government securities lessening the Treasury yield curve inversion
• A disconnect between Fed guidance on rates and the economy and financial markets expectations persists
Below are select Bloomberg fixed income index returns thru Q1 2023 and year:
Are We There Yet?
Fixed income markets were off to the races in January following a tumultuous 2022. Riskier sectors outperformed as the year began with high yield debt, for example, registering historically strong returns in the first month of the year. Yields continued to rise in February with the FOMC continuing its “hawkish” monetary path as prices continued to rise in many sectors of the economy and the labor market continued to show strength. Encouraged by falling oil prices, with a particularly mild winter in Europe, a strong domestic labor market, and a faster opening of the Chinese economy, investors were eager to embrace yields that, in some credit sectors, rivaled long term equity returns for a short period of time before banking issues caused a dramatic reversal in March.
Yields declined precipitously during the month of March following the high-profile closures of Silicon Valley Bank (SVB) and Signature Bank by the FDIC. In retrospect, the banking models and risk management practices at both institutions raise many questions, but the swiftness of the deposit runs in both instances caught regulators off-guard and sent ripples through the regional banking sector nationwide. While there are clearly widespread pricing issues in bank portfolios, with fed funds starting near the “zero bound” and increasing 475 basis points over a period of only twelve months, any “contagion” appears to be mostly subdued as depositors have begun to relax and federal programs in place (the Fed Discount Window and the newly established Bank Term Funding Program) serve to provide safety and liquidity where needed in the system. The usage amounts at both these facilities will be helpful to monitor as a measure of ongoing stress in the system.
To combat inflation, historically, the Fed Funds rate has been raised to a level higher than the current rate of inflation. In 1981, then FOMC Chair Paul Volcker famously raised the Fed Funds rate to 20% to force inflation down from its peak near 15%. Within a period of two years inflation was successfully brought down to a more reasonable 3%.
Today the Federal Reserve has more tools at its disposal than just the Fed Funds rate and it is monitoring a wider array of economic indicators in order to effectively execute its dual mandate of price stability and full employment. Although numerous segments indicate trending declines, inflation measures remain stubbornly high no matter which indicator is being used- Headline CPI was 6% last month, Core CPI was 5.5%, and the Core PCE deflator was 4.6%. While current monetary policy is primarily the result of inflationary pressures, and the Fed is relying mostly upon lagging indicators to dictate future actions, we believe the Fed may be winning the fight against inflation with a lower Fed Funds rate.
There are currently two conditions primarily aiding the FOMC in imposing tighter monetary conditions along with the Federal Funds rate. The first is “Quantitative Tightening”, allowing the Fed’s holdings of Treasuries and mortgage-backed securities added during the pandemic to gradually “run off” of their balance sheet. The second comprises newly restrictive credit conditions within the banking sector resulting from the collapse of SVB and Signature Bank mentioned earlier in this commentary. Both conditions appear to be tempering the amount of Fed Funds rate hikes needed to quell inflation and suppress demand within the US economy.
According to statements made by FOMC Chair Jerome Powell following the most recent meeting in March, safeguarding the stability of banks has taken precedence over the need to slow inflation. That said, a 25 basis point rate hike was still implemented, Powell indicated an additional hike may be needed in May, and he was also clear that no plans are currently on the table to reduce the Fed Funds rate for the remainder of 2023. By pushing forward, even given ongoing banking risks, the FOMC not only demonstrated resolve to bring down inflation, but also exhibited a vote of confidence in the soundness of the US banking system. Numerous Fed speakers in recent weeks have echoed this message.
We are in the camp of those that believe the Fed has likely reached, or is very close to, its terminal rate for this tightening cycle. However, we also believe the Fed may hold at or near this Fed Funds level for an extended period to allow measures already in place to have their intended effects on the economy.
As mentioned in several of our recent fixed income commentaries, the markets are often at odds with the latest Fed guidance. Such is the case at present with Treasury futures markets currently factoring in three rate cuts- reducing the Fed Funds rate to around 4% by year-end.
Volatility in the fixed income markets remains quite high and expectations can swing dramatically with a single comment from a Fed speaker or a data point from a monthly inflation or jobs report. A broad divergence of opinion on the direction of interest rates and monetary policy simply makes our job more challenging.
US Treasuries have played their traditional role during the recent “flight to quality” and further displayed the diversification qualities available from fixed income with the recent normalization of interest rates. The current Treasury yield curve inversion (the negative disparity between very short-term Treasury yields and longer maturities) reflects market sentiment focusing primarily upon the likelihood of ongoing banking issues as well as a pending economic recession. It is also another clear signal the market is discounting Fed guidance.
At present, it is fairly clear that work needs to be done to shore up regulatory oversight and funding sources at many of the nation’s smaller banks. Further, fallout from the banking shock in March will likely slow the flow of credit from regional banks across the country and, similarly, pose potentially adverse effects to both consumer confidence and economic development. Still, we believe the current rally in longer dated Treasuries may be overdone and are selectively looking for opportunities in corporate credits and the municipal sector without taking undue duration risk. In addition, high relative short-term yields and dislocations in the banking sector should also create opportunities in select bank credits and structured rate or securitized securities suitable for liquidity portfolios.
As stated in our previous quarterly commentary, we believe 2022 was a pivotal year for fixed income. A much needed reset in rates has begun to normalize bond markets allowing for more generous cash flows and more predictable long-term performance. In following, although most bond indices underperformed the S&P 500 during the most recent quarter, core fixed income has regained its function as a risk offset for more aggressive allocations in our client portfolios. Very legitimate questions remain regarding the persistence of inflation, labor market strength, and the Fed’s resolve to restore price stability, as well as the health of the global economy in general. We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts.
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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