Picking our spots
Volatile markets can offer opportunities.
Municipal market yields nearly kept pace with declining Treasury yields in the first quarter as investor demand was robust and muni supply remained muted. The stress in the banking sector that prompted strong returns for high quality fixed income, including munis, likely will contribute to downside risk for the U.S. economy in coming months. Fortunately, munis as a group are approaching the likely economic slowdown or recession from a position of relative strength. In fact, some of the highest profile mid and lower quality governmental borrowers in the market, including the states of Illinois and New Jersey as well as the Chicago Board of Education, were recently upgraded. This is reflective of the broad trend toward stronger balance sheets for many state and local governments—an outgrowth from the large federal Covid relief packages, strong tax revenues arising from the economic expansion and rising property values in much of the country. There are lurking risks, however. The likely decline in commercial real estate valuation in coming years will erode local tax bases in certain areas of the country and a U.S. recession would certainly depress state income & sales tax revenues. — R.J. Gallo
Volatility was the name of the game on both rates and spreads (rate differentials relative to Treasuries) in Q1. In the first two months, markets grappled with the remnants of the prior 10 months’ historic pace of Fed rate hikes, and then in March dealt with a large consequence of those hikes: a regional banking crisis. Because we took profits in late 2022 on our shorter duration and yield-curve inversion calls, Federated Hermes fixed income portfolios “locked in” much of their relative outperformance over the prior eight consecutive quarters. By sticking with an underweight to corporate bonds hedged to some degree with overweights to EM and U.S. agency MBS, this positioning also helped generate positive returns in line with the Bloomberg US Aggregate and US Universal Bond indexes in the first quarter.
Looking forward, with investors torn between the Fed’s insistence on further rate hikes and a market haunted by visions of 2008 insisting maybe not, we continue to position cautiously. That means neutral across most of our fixed-income franchise, be it rates or sector, with no outsized bets either way. We again enter a new quarter with continued below-benchmark exposure to investment-grade (IG) and high-yield corporates (though minimally so on IG), a slightly larger overweight to EM where a near double-digit coupon justifies the additional spread risk, and a larger overweight to MBS where prepayment risks are almost nil, inventories are extremely tight and wide spreads present opportunities.
In other words, we’re picking our spots in a market that, except for a spike in the early stages of the pandemic, hasn’t been this volatile since the global financial crisis. With the Fed raising policy rates at its fastest pace in history, causing Treasury rates to soar in step and the yield curve to massively invert, there’s always the fear that something may break. Was the banking panic spawned by the second- and third-largest bank failures in U.S. history, followed days later by the forced marriage of global giant Credit Suisse with even larger Swiss megabank UBS, a sign of much worse things to come in the sector? Our strategists don’t think so. But while the banking panic appears to be subsiding, its ripples haven’t ended yet. We still need to see how this plays out.
In the meantime, the latest economic data (the smallest increase in nonfarm payrolls since December 2020, the slowest pace of job openings in 21 months, the lowest manufacturing ISM reading since May 2020) suggest the economy is slowing. Prices, while elevated, look to be easing, too. Will this, and the banking turmoil, be enough to put the Fed on pause? We’re more skeptical than the markets but are somewhat uncertain about what happens in late summer and fall. Some market participants expect a potential quarter-point cut or two by year-end. Others see policymakers holding steady. Either would suggest we’re nearing if not already at “peak Fed,” which is supportive of our 5-year/30-year steepener call on the Treasury curve. Might a 2/10-year bull steepener be next?
That answer depends on what the Fed and economy do next. With the 2-year already having rallied 110 basis points off its mid-March high, a lot of “peak Fed” arguably is already priced in. And if the economic data continues to soften, recession worries could take the 10-year lower. Not sure a steepener (that’s the consensus call and we’re never comfortable being with consensus) would work there. In fact, we’re holding duration at neutral for now in part because we think the 10-year’s nearly 60 basis-point drop on the banking panic may have overshot the fundamentals. With wage growth greatest at the lower end of the income spectrum, excess savings greatest at the higher-income end and both corporate and household balance sheets still relatively healthy, there are a lot of underlying positive economic forces still at work. But rate increases tend to hit with significant lags (how much is debatable—has the historic 12-to-18 months shrunk to nine-to-12 months in this rapidly moving global economy?), suggesting impacts from the past year’s record tightening are just starting to take root. Hard to say with conviction which way things may break. So, until we get better clarity, we’re picking our spots.