The last mile is the hardest

After a 75 basis-point decline in the fourth quarter of 2023, markets reversed course and the yield to maturity of the Bloomberg Aggregate Bond Index increased by 30 basis points in the first. This produced both negative price returns and overall negative total returns for the Agg and related core bond indices. While this reversal may seem somewhat inconsistent with the Federal Reserve having signaled a pivot to rate cuts this year, it is a reminder that the markets often run ahead of policymakers. The inflation decline reported in fourth quarter caused investors to assume—and cheer—changing sentiment from Chair Jerome Powell and the Open Market Committee. As is often the case, the bond market moved too far, at one point discounting as many as six rate cuts for 2024. Ultimately, the lack of sustained improvement on inflation in the first quarter caused a retracement of almost half of the fourth quarter rate decline.

We have been, and continue to be, skeptical that inflation data will allow the Fed to make significant easing moves in 2024. After the U.S. 10-year declined to near 4% yield levels in February, we shortened our target duration back to neutral. This reduced our exposure to rate volatility, helping to preserve some of the price improvements in our portfolios in fourth quarter.

Historically, the last leg toward a given inflation target has often been the most difficult. Market participants, in anticipation of Fed action, tend to create an environment in both rates and spreads that make financial conditions easier than the target rate implies. A circular argument occurs, in which the market and policymakers try to anticipate each other’s moves. As the second quarter begins, the fed funds level, in place since July 2023, has not pushed inflation to complete the last mile from 3% to 2%. This is what keeps us from a long duration positioning. At the same time, real rates—at 2% as measured by the 10-year TIPS yield—appear to be fairly valued or even cheap relative to historical averages, discouraging us from a defensive duration position

Bigger opportunities in the yield curve

While the duration decision feels relatively symmetric, the direction of yield curve shape changes seem inevitable. While inverted curves have lasted for long stretches at times, they have always reverted to positive slopes. Much of the market seems to be focused on a bullish steepener, i.e., shorter rates falling to levels lower than a 4.5% 10-year. But we believe a bearish steepener, one where the long end gets impatient or even skeptical about whether 2% inflation can be achieved, is almost equally as likely as a bullish steepener. Thus, we have been dedicating more of our risk budget to our yield curve Alpha Pod. In other words, we like a how a neutral duration position allows the steepener call to work regardless of the direction of rates.

Diversified alpha sources within a diversified alpha source

Along with sticky inflation, leading indicators of U.S. growth have largely surprised to the upside, driving upward revisions in current and upcoming quarterly growth forecasts. Labor market data also remains strong, with initial claims consistently around 200,000 and recent payrolls data consistently above expectations. The unemployment rate is off its lows but remains at levels consistent with a healthy job market sufficient to produce real wage growth. 

Risk assets, including lower quality credit, have outperformed recently amid ongoing economic and earnings growth. The Fed’s asymmetric position, to hold rates or perhaps ease, likely also has contributed to the risk asset rally. 

The continued grind tighter during the first quarter moved high yield spreads to historic levels of tightness. They have been wider 97% of the time over the past 38 years. We’ve experienced a Teflon market—with some notable blow-ups but only affecting the specific issuer. Defaults haven’t spread and become more systemic…so far! At tight levels, it doesn’t take much widening to offset the yield advantage and the widening can happen very quickly, so we remain cautious on the medium- and lower-quality corporates within our Sector Pod.

To offset, or diversify against, the corporate underweight, we have been overweight the mortgage-backed securities (MBS) sector as well as emerging market (EM) bonds. Neither of these has spreads as historically tight as U.S. investment grade and high yield. Due to a large percentage of discount coupons, the MBS sector is not nearly as negatively convex (i.e., not as much pre-payment risk) as is typically the case prior to past sell-offs. Rising oil prices are supporting EM, as is the sector’s reduced reliance on lower U.S. interest rates.

When does the market start focusing on the election?

Fiscal policy in the U.S. remains unsustainable as the country moves into an election. Neither party has a favorable track record lately on the issue of deficits and debt sustainability. That said, market concerns about these merely simmer, as worries about Fed’s actions, growth and inflation boil

While there may not be major differences in the deficit outlook, trade policy and issues of globalization will be on the ballot as the candidates have notable contrasts. As the election heats up, generating more focus on candidates’ views, the simmer could reach that boil. Conventional wisdom is that the market focuses on the election after Labor Day; our expectation is this year it will happen sooner, so we plan to be on full alert.