Bonds Perform Well in Risk-off Environment

Core bonds finished the second quarter with a gain of 1.16%. Results were driven by stable interest rates and positive excess returns from corporate bonds and mortgage-backed securities (MBS). For the quarter, corporate bonds outperformed Treasurys by 1.05%, while MBS was slightly better than Treasurys. Over the last 12 months, the return on core bonds has been 6.01%.

The 10-year Treasury began the quarter at 4.21% and finished just two basis points higher. This led to positive returns from yield capture. Despite the generally stable yield levels, there was a notable trend toward a steepening in the Treasury curve. The spread between the yield on 30-year Treasurys and 5-year Treasurys widened by 38 basis points. The number of expected interest rate cuts remained near three, although it dipped close to two during the quarter. The Federal Open Market Committee (FOMC) held the Federal Funds rate unchanged at 4.5% but did note they would be biased to look through tariff-related inflation.

Economic data has morphed into an ambiguous image, appearing at various times to resemble strength, weakness and stagflation. Tariffs are
no doubt impacting the timing of orders and market swings are impacting near-term consumers’ propensity to spend.

  • The Citigroup Economic Surprise Index moved nowhere during the quarter, while remaining near zero.
  • Actual inflation readings are stable, but survey-based prices paid components remain elevated.
  • The purchasing managers’ index (PMI) prices paid was 69, while new orders and employment were under 50.
  • ADP private payrolls showed a contraction of 33,000 jobs in June, while the three-month net change of +56,000 is by far the weakest three-month period since 2020.
  • Yet, the Job Openings and Labor Turnover Survey (JOLTS) report shows more than a 550,000 increase in job openings over the last two months.

Strategy Positioning

Our strategies are positioned slightly underweight on duration from a secular standpoint. We moved the duration up to just below the index as the odds of employment surprising to the downside appears to be moving higher. While this may just be noise within a sustained economic expansion, it appears the political pressure on the Fed will cause them to react quickly to any two-month weakness in employment. This would expand the number of expected cuts and bring the entire Treasury curve lower, while continuing with the steepening theme. If these cuts are completed, and within the context of a sustained economic expansion, then it exposes upside risk to inflation over the next three to five years.

Our strategies are overweight corporate bonds and MBS. The conditions for recession don’t appear to be in place. Also, communication from the Federal Reserve suggests a quick response to any economic soft patch. While this wouldn’t stave off a recession if they had been too tight on policy for a sustained period, it would work if we hadn’t yet had the conditions for a recession. The Fed has cut 100 basis points already and another 50-100 combined with a 6-7% fiscal deficit would be a powerful pre-emptive move in the context of generally stable economic data. Corporate bonds would likely continue to outperform in this environment.

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.

This content is provided for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Statements in this report are based on the views of BTC Capital Management and on information available at the time this report was prepared. Rates are subject to change based on market and/or other conditions without notice. This commentary contains no investment recommendations and should not be interpreted as investment, tax, legal, and/or financial planning advice. All investments involve risk, including the possible loss of principal. Investments are not FDIC insured and may lose value.