Bonds Bounce Back
After posting the worst quarterly decline since 1981 in the first quarter, it should not come as a shock the sector bounced back during the second quarter. Fixed income returns for the quarter were positive as long-term Treasury yields peaked in early April. The Bloomberg Barclays Aggregate Bond Index was up 1.8% for the quarter with heavy gains attributed to 30-year Treasuries and corporate bonds. Corporate bonds once again outperformed, led by lower rated issues as well as longer dated tenors. 30-year Treasuries returned around 5% on the quarter as their yields fell from 2.41% to 2.08%. Two-year Treasuries were down on the quarter.
The highlight of the quarter in the fixed income market was the flattening of the yield curve. Despite rising prices across the board, the curve flattened significantly. Two-year Treasury yields rose nine basis points while 30-year yields fell 33 basis points. This was driven by the market anticipating peak inflation as the year-over-year commodity price increases roll off, as well as a more hawkish Federal Open Market Committee in their last meeting.
The Federal Reserve (Fed) raised their median number of forecasts in 2023 and indicated they would not hesitate to react to inflationary pressures should they view them as more than transitory, which they do not at this time. Still, a more hawkish Fed with a market view that inflation will be falling is enough for the Treasury curve to flatten. This is because the market views the main risk as hiking rates into a weakening economy. Should inflation persist at a higher level and the Fed hesitate and be deemed to be behind the inflation curve, then it is likely the Treasury curve will resume a steepening trend.
Positioning and Outlook
We anticipated the events of the second quarter would transpire, except we thought they would happen in 2022 and not this year. Our leading indicators on growth and inflation continue to point to acceleration, therefore we think there will be a temporary scare at some point this year regarding inflation and the possibility that the Fed is behind the curve. This should result in a long trend of Treasuries underperforming and we are positioned for this scenario. Given the huge debt burden, it is unlikely that credit growth can persist for long enough to meet out of control inflation. Still, a higher low and re-acceleration in the Consumer Price Index should be enough to help re-price longer dated yields to higher levels.
There are, however, several good reasons for yields to stay low. One often cited example is China’s credit impulse rolling over. However, we do favor the fact that 97% of the 39 countries reporting to the OECD have leading economic indicators that have increased over the last three months, and 100% showed month-over-month gains. The global economy continues to accelerate. Should the growth indicators roll over, then we would extend duration, as there would likely be much more upside to long-term Treasury prices. This scenario would certainly keep the Fed on hold and the market would likely price in permanently low yields on the long end, not unlike what we have seen in Europe. If you cannot raise rates with the largest GDP expansion on record and highest inflation readings in decades, then you probably never can. At least until there is debt forgiveness or a major overhaul toward persistently higher fiscal spending.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet, Refinitiv.
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