Yields Move Higher Sharply, Amid Strong Economic Growth

Core bonds dropped 3.5% during the third quarter as the 10-year Treasury yield hit a 24-year high. Inflation continues to track well above 2%, and economic growth shows no signs of slowing down. It looks as though the seven cumulative cuts engineered by the Federal Open Market Committee (FOMC) between 2024-2025 are starting to feed into accelerating economic growth at a time when inflation is already above 3%.

Corporate bonds underperformed Treasurys for the quarter. Their one-year performance advantage has been slowly eroding. Mortgages fared notably worse with excess returns in the quarter of -120 basis points. Spreads were very tight in the space and 12 basis points in widening resulted in notable underperformance versus Treasurys.

Pro-Cyclical Policies

Regarding our SMA strategies, we have maintained the view that the Federal Reserve was not restrictive with their policy. On top of this, the fiscal reaction function has prioritized growth over stable inflation in the six years since COVID.

  • Core PCE has been above 2% for 66 consecutive months.
  • Second quarter Nominal GDP (SAAR) was 8.5% and the highest in four years.
  • The federal deficit has exceeded 5% in 71 of the last 77 months.

Adding to the above data points, the Citi Surprise Index has been above zero for more than 200 consecutive days. This is the second longest streak in the 23-year series. If it reaches 248 days, it surpasses the post-COVID expansion. Against this backdrop, it appears that both the monetary and fiscal reaction functions continue to lean heavily on pro-growth policies and less so on bringing down inflation. Two of the most influential FOMC members, Vice Chair Jefferson and New York Fed President Williams made notably dovish comments in recent weeks. Williams said there was no urgency to raise rates at the upcoming FOMC meeting. Vice Chair Jefferson said the Fed may need more time to assess the economy before additional rate hikes. This month, President Trump said that certain levels of inflation could help pay down the debt very rapidly. David Zervos was recently named a Counselor to the Treasury Secretary. The former Jefferies economist has a strong disinflationary view when it comes to the AI build out. He favors interest rate cuts to prevent any unnecessary slowing in growth. And lastly, he favors the Treasury taking a strong presence to stabilize long-end yields via actively buying back longer dated bonds.

Strategy Positioning

We continue to think the policy environment will result in higher interest rates over the coming quarters. Aside from tactical shifts to neutral, we expect to have duration below benchmark until policy reaction functions are stronger on the inflation fighting front. Spread products remain overvalued, but in the context of an expanding economy we maintain a neutral positioning. We are targeting incremental outperformance from corporate bond security selection and modest tilts to our duration positioning.

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.