Mosaic of uncertainties merits caution
Bonds wrestle with pricing Fed, war and inflation outcomes.
Municipal securities struggled with the rest of the bond market through a quarter that saw Treasury yields jump on very high inflation, worsening price pressures from Russia’s invasion and the Fed’s shift to aggressive hawkishness. The rapid rise in rates depressed bond prices and prompted a surge in redemptions across the bond universe, and the municipal market was no exception. That said, losses on tax-exempt munis were a somewhat less negative than those experienced in some corners of the taxable bond market as munis remained supported by favorable credit fundamentals and the prevalence of still in-the-money callable bonds diminishing overall duration. Many state and local governments are cash rich, a result of both large Covid-relief transfers and revenue growth arising from strong economic performance and rising property values. Similar to the spread widening seen in the corporate sector, the relative value of munis to Treasury securities cheapened during the volatile quarter as investor demand waned, driving muni ratios to close the quarter at levels consistent with long-term medians. – R.J. Gallo
Well, that was ugly. The hottest inflation in four decades, a Fed that went full-bore hawkish and a tail-risk event (Russia’s invasion of Ukraine) that was just a blip on the probability radar at the start of the year made for the worst quarter for the broad bond market since 1980. The good news—if we dare call it that—is having positioned more cautiously at the start of the year on worries rates would rise, most of our fixed-income strategies outperformed their benchmarks on a relative basis in the first quarter. They still posted losses, just less so.
The question is, where does the market go from here? We don’t see how it suddenly turns constructive. It’s reasonable to expect some retracement of rates after the 2-year U.S. Treasury yield spiked 161 basis points, the 10-year jumped more than 82 basis points and the 30-year rose 55 basis points in a brutal bear flattener in the first quarter. But the bias remains higher. Too many forces are working in that direction, starting with inflation that has yet to display signs of moderating and an economy that, as reflected in employment and other macro data, continues to hum despite the weight of higher prices. Minutes from the Fed’s March meeting liftoff and comments since show policymakers expecting to move harder and faster, with possible 50 basis-point moves and accelerated balance sheet runoff.
At the Fed, patience gives way to urgency
The Fed’s abrupt shift from nearly two years of uber-dovishness suggests it understands what we have been saying—it’s fallen well behind the curve. It is now walking a very thin tightrope between tightening enough to stall runaway inflation and too much to cause recession. It may in fact take a recession to rein in inflation. That’s not our current base case for this year but the work ahead is formidable. In February, core PCE and core CPI accelerated to 39-year and 40-year highs, respectively, and this was before the Russia’s war on Ukraine—two global centers for oil, gas, foodstuffs and critical metals. The conflict and accompanying sanctions sent energy and commodity prices soaring. Even if there’s a cease-fire, it’s doubtful a West stunned by Russian atrocities and brutal attacks on civilians would lift the sanctions, which along with emerging Covid cases in China are re-stressing global supply chains that were showing signs of healing.
The war arguably came at the worst possible time for the Fed, undermining progress on supply chains just as inflation’s reach already was broadening to “stickier” areas such as shelter (home prices are at record highs) and wages. The Atlanta Fed’s wage growth tracker shows wages rising at 5.8%, their highest pace since the series started in 1997 and really since 1983 if the regional Fed bank’s extended version of the model is used. Once higher wages and prices settle into American psyches, the structural wage-price inflation can be very hard to break. Just ask those of us who lived through this in the 1970s. And there are signs these expectations are starting to take root—the University of Michigan’s year-ahead expected inflation rate among U.S. consumers hit a 41-year high of 5.4% in March. On a positive note, those expectations five years out were unchanged at 3%.
The question is, “How much is priced in?”
The good news is that the Fed’s recent communications have been so hawkish that the market is pricing in a federal funds rate of 2.50% by year’s end, even more tightening than the Fed’s March dot plot suggest. This indicates the run-up in rates could moderate from current levels and, as indicated above and as occurred toward the closing weeks of the first quarter, even have occasional periods of retracement. With the hawkish Fed perhaps more than priced in, it likely will take many months or quarters to figure out whether inflation does decelerate sharply as suggested by the recent inversion in the Treasury Inflation-Protected Securities curve. Alternatively, if inflation remains too hot, the Fed terminal rate projections may still prove to be too low. We would bet on the latter.
Given this mosaic of uncertainties, we entered the new quarter adding to defensive positions we’ve been building over the past year. We moved from neutral to underweight in our two most significant credit buckets, investment grade and high yield corporates, held at neutral in emerging markets (the runup in energy and other commodities present upside opportunities in some countries and headwinds in others), and continue to favor lower-duration assets such as floating-rate bank loans, trade finance and credit asset-backed securities. Our biggest spread product position, while still not huge, is an overweight in agency mortgages, where steady bank demand should offset a pending, and gradual, Fed exit amid attractive spreads and elevated volatility. We again expect rate strategies to be significant sources of alpha across our portfolio models, albeit less so than Q1. On duration, we are modestly short of the benchmark on expectations yields are more likely to drift higher than rally. And we’re neutral on the yield curve after being correctly positioned in a flattener in Q1. We stand ready to react tactically and quickly on both fronts as needed. But until we get better clarity on the future paths of inflation, the economy and Fed, conditions merit caution … again. Better to be safe than sorry.