Bond clouds starting to part

No sugarcoating 2022—the worst for bonds since the 1790s, a Santa Clara University business professor says. The broad Bloomberg US Aggregate Bond Index returned -14.6% through September, a record decline for the first nine months. The “safer” Bloomberg US Treasury Index returned -13.1%. The good news: The Fed’s recent hawkish policy stance helps ensure that relief is on the way. A significantly higher starting point on income (September breached 4% on the 10-year Treasury yield and the 4.5% yield-to-maturity on the Agg likely isn’t far from where yields may peak), and a market that is discounting future Fed increases and a possible recession, create the potential for positive total returns going forward. Will rates stabilize or decline by year-end? Possibly. Not ready to make that call yet.

First, we need more clarity on how much “pain,” as Chair Powell put it, the Fed inflicts. It seems certain to keep hiking into the new year and to hold tight once it gets where it wants to be (we’re thinking a terminal rate around 4.50%). Policy rates already have jumped a Volckeresque 300 basis points off mid-March’s zero-bound, and both September Fed projections and futures indicate additional increases of 125 points by early 2023. Despite wishful risk-market whispers of a pause or slowing, Fed policymakers keep pounding their hawkish message. They’re determined to get inflation down toward their 2% target, and the bond market is taking them at their word. The TIPS 5-year breakeven rate ended Q3 at a 20-month low 2.15%, and almost all the Treasury curve has inverted.

It's all about “sticky” inflation …

As long as core rates keep running hot, the Fed arguably has a single mandate, and it will be challenging. Rents, which account for about a third of CPI, accelerated in August, lifting core CPI to a 5-month high. Wages keep rising at nearly a 7% annualized rate, the fastest in the nearly 26-year history of the Atlanta Fed’s wage-growth tracker. With home prices near record highs and the labor market still historically tight, these two structural forces are unlikely to rapidly reverse. It doesn’t help that food prices remain a problem. In August, they posted their biggest 12-month increase since May 1979. Energy, too. As the world’s second- and third-largest producer of natural gas and oil, respectively, Russia is utilizing its pricing and production to weaponize the resources and keep prices near their cycle highs. Last week’s decision by OPEC+ to cut oil production is one example.

… even at a cost of possible recession

Rate increases, which hit with a lag, have started to bite in an economy already struggling with pandemic-related supply shortages and fallout over Russia’s invasion of Ukraine. Along with record prices, a doubling in mortgage rates has sent rate-sensitive home sales plunging, and home construction is slowing, too. Manufacturing and services activities are decelerating, and forecasting firms are sounding recession alarms. A big offset: a strong jobs market, though it is starting to show cracks. August saw the biggest drop in job openings since the pandemic’s start. Still, there were 1.8 openings for every unemployed person, and even if the jobless rate rises to 4.4% next year, as the Fed projects, it would be historically low. Consumer and corporate balance sheets are in good shape, too. Nothing like typical pre-recession stress levels. These counterbalances suggest a recession, though a relatively high probability, is likely to be less severe than the ’20 Covid recession or the ’08 financial crisis.

Cautious on credit; potential in Treasuries

• After adding significant value by being overweight credit in the 18 months after Covid hit, the last nine months of stagflation have led our models to underweight high yield, investment grade (IG), commercial MBS and less so emerging market debt on concerns about further spread widening, weakening macro conditions and rising defaults. That said, underlying credit conditions remain relatively healthy, with marginal rate exposure among the vast majority large-cap companies (ex-financials and real estate), and spreads nearing an end point that would argue for adding exposure. Just not yet.
• Within our broad credit underweights, there may be selective value in lower quality credits (BBB and financials in IG, mid- to higher-spread issuers in high yield) because of strong underlying credit conditions and earnings that may slow but remain largely OK for bond investors. With a nod toward potential countervailing effects from a slowing economy, shorter-term floating-rate loans and municipal securities also offer value. Low-duration strategies should benefit relative to long-duration instruments but confront challenges from persistent increases on the short end. For instance, in the 1- to 5-year government/credit space, investors can get nearly all the forward-looking yield with only 60% of the interest-rate volatility of a core-duration portfolio. This works well in a low volatility/stable yield-curve environment, albeit relatively less so if the market experiences further inversion.
• While interest-rate volatility may continue, by definition we are closer to the end than the beginning of the rate cycle. We think the mortgage market, which already is priced to a high level of rate volatility, presents opportunities. (An overweight to mortgages in July generated a large contribution to our multi-sector strategy performance that we subsequently took profits on before the market turned negative again in August/September.) At present, we are again overweight this asset class on spread valuations, although not yet at max, as the challenging issue of finding buyers in a market where the Fed has pulled back still exists.
• Treasuries and agencies merit monitoring on the belief we’re closing in on peak yields. Even if yields keep rising, there is now at least a reasonable level of income to offset potential price declines while the potential for price increases improves as the Fed gets closer to its terminal rate.

Rate strategies sniffing an end point

The face-off between the Fed and inflation has created a dichotomy for rate positioning, with a higher terminal rate competing with the outcome, i.e., a slowing economy and possible recession. Duration has generated a significant amount of alpha year-to-date in our model portfolios, which were mostly short the first half of 2022 as rates rose and have been hovering at or near neutral since as rates have been somewhat rangebound. A falloff in economic activity that slows inflation as much as forward markets seem to think will occur raises the potential for going long. With the Fed and European central banks in the middle of aggressive rate-hike cycles, a flatter to more inverted yield curve is the base call for yield-curve positioning, although this position is also becoming “late in the game.” The dollar has risen so dramatically that the best opportunities may lie in tactical shorts against this one-way trade, or in currency pairs within specific markets.