The Federal Reserve Ends Easing Bias

Core bonds finished the second quarter with a gain of 0.7%. Oil prices would fall more than 30% as the U.S. – Iran conflict eased. This helped reduce inflation expectations, which took bond yields off their worst levels of the year. Corporate bond spreads tightened by 14 basis points in the quarter, which resulted in excess returns of 1.12%. The mortgage sector lacked the torque but still had 20 basis points of excess return versus Treasurys.

  • Oil prices retrace; bond yields don’t.
  • Corporate bonds outperform.
  • The Fed has a new Chair.

The 10-year Treasury began the quarter at 4.32% and finished 12 basis points higher at 4.46%. Despite the retrace in oil prices, Treasury yields remain in the upper half of their year-to-date range. Falling oil eases near-term inflation pressure but supports sustained economic growth. This is further enhanced by improving labor market data. Nonfarm payrolls posted their highest three-month rate of change in more than two years. Job openings have turned higher and jobless claims remain near historic lows.

The Federal Reserve has a new Chair for the first time since 2018. The Kevin Warsh-led Fed removed their easing bias with the market now anticipating a hike by year-end. The 2-year Treasury yield has moved about 70 basis points higher this year.

Corporate bonds bounced back in the second quarter, taking their cue from the risk on equity rally amid easing tensions in the Middle East. Corporate bond spreads are now more than two standard deviations below their five-year average. The risk/reward is not favorable currently; however, this does not necessarily warrant an underweight position. Corporate bonds were in a similar position one year ago and have outpaced Treasurys by 174 basis points over this span

Strategy Positioning

Our strategies are positioned slightly underweight on duration from a secular standpoint. We maintain our now lengthening outlook that Fed policy is not as restrictive as market consensus would indicate. We think there is room for the Federal Funds rate to move closer toward nominal GDP without causing a significant slowdown in economic activity. The recent acceleration in labor market conditions may become a bigger focus in the second half, and if sustained, could lead to future interest rate hikes.

The strategies are neutral on corporate bonds. Spreads offer a poor risk/reward, but this is offset by still favorable conditions for equities and risk products in general. We continue to target wider sectors where there is opportunity for spread tightening. Our overall weighting to corporates has been declining as we add these wider names. The net result is roughly neutral beta to corporate bonds.

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