Inflection Point – From Tightening to Easing
Broad market high grade bonds declined by -0.8% this quarter reducing their year to date return to 2.2%. Yields across the curve rose as short-term rates rose more than long term rates. Treasury bonds with a 1-year maturity climbed from 4.6% to 5.4% while the 10 year maturity rose from 3.5%to 3.8%. This front-end rise was fueled by the Federal Reserve which signaled further rate hikes to the overnight borrowing rate to tame inflation to achieve their 2% Consumer Price Index target rate. The Federal Open Market Committee (FOMC) turned more hawkish at their last meeting as they revised the median dot higher in their 2023 dot plot of rate levels, showing two additional hikes in the second half of this year. The FOMC’s 25 basis point (bps) increase this quarter seemed like a pause versus a signal for higher rates, following the pace of the last 15 months which saw the FOMC’s overnight rate climb to 5%, pushing U.S. prime rates to 8.25% for large corporate borrowers.
We favor a modest decline of rates in the second half of 2023, retracing to where the first quarter ended. We believe a slowing economy is likely to keep the FOMC in check with no more than one rate hike, pausing until the second half of 2024. Traditionally, the Treasury yield curve has steepened with a sharp decline in yields in the months following the last rate hike of a Fed tightening cycle. First, we anticipate a slower progression to lower rates as the Fed’s rate pause will
last longer than the traditional seven-eight months of previous cycles. Second, we expect weak demand from less price-sensitive buyers for the increased supply of Treasury bills and notes following an issuance pause due to the debt ceiling. Lastly, the Fed continues to reduce its balance sheet by shedding Treasury holdings, while banks cut their Treasury holdings as the disintermediation of bank deposit to money market funds continues.
Corporate bonds outperformed the broader market returning -0.2%, which reduced their year-to-date advance to 3.2%. Spreads on corporates relative to their Treasury counterparts stand at 123 bps, down 10 bps. for the quarter and in line with the five-year average of 124 bps. During previous periods leading up to a recession this spread has widened to reflect the increased credit stress on a corporation’s ability to service its debt. So far credit markets do not reflect a deep recession and we anticipate corporate credit spreads will remain rangebound in the second half. Risks around this view are two sided. Lower spreads anticipate a faster reduction in inflation coupled with a moderate decline of GDP growth and lower volatility. Whereas a widening of spreads would result in a deeper recession and relative lower returns.
Residential mortgage-backed bonds declined 0.5% for the quarter reducing their year-to-date return to 1.9%. Mortgages look cheap from a technical perspective based on the following; changes related to a reduction in purchases by the Federal Reserve, a lack of bank buying, and FDIC sales attributed to two large bank failures. Strength in home prices and the stabilization of duration in this sector has benefited mortgage credit following a year when duration extension made this sector more interest rate sensitive to a rising rate environment.
Returns of municipal bonds aligned with other bond sectors as longer maturity bonds outperformed shorter maturities with this sector posting a year-to-date return of 1.1% and -0.7% for the quarter. We favor municipal bonds with maturities of nine years or longer as lower demand from bank buyers has kept that segment of the market cheaper than other parts of the curve. While state and local tax receipts declined 3.5% during the first quarter of 2023, they exceed the 5-year trailing average by 18% providing a strong buffer for this sector’s credit quality in the event of a recession.
The information provided has been obtained from sources deemed reliable, but BTC Capital Management and its affiliates cannot guarantee accuracy. Past performance is not a guarantee of future returns. Performance over periods exceeding 12 months has been annualized.
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