Perspectives

Following the dovish Fed pivot in December that opened the door to easing monetary policy for 2024, the fixed income market entered the year anticipating steep rate cuts beginning as soon as March. But an unforeseen streak of stronger economic data and a few stubborn inflation prints forced investors to recalibrate monetary policy and growth expectations for the new year. The widely held goldilocks view of a soft landing and moderating inflation was called into question by the prospect of an overheating economy and inflation data that, at a minimum, was taking its sweet time coming down. Investors were forced to reconsider the timing and cadence of the Fed’s reaction function, and in due course rate cut expectations were aggressively dialed back from six to three. The Fed appeared relatively unfazed by the stronger growth and inflation data, holding rates steady for a fifth consecutive meeting and keeping three rate cuts on the calendar for the year.

Treasuries

The hotter than expected inflation readings along with significantly pared back policy expectations pushed nearly the entirety of the Treasury yield curve approximately thirty-plus basis points higher. The closely watched 10-year Treasury yield settled at 4.20%, returning to a level last seen at December’s dovish pivot. As rate cuts were priced out of the market the yield curve reversed its steepening trend, leaving the slope little changed and firmly in negative territory.

Credit

Credit spreads continued their steady grind tighter, supported by upbeat economic data, a dovish Fed, strong corporate earnings and the hunt for yield. This movement drove investment grade spreads to within a few basis points of their post-GFC tights. High yield spreads closed sub-300 OAS for the first time since January 2022. The march tighter in spreads is striking in an environment of record investment grade issuance and the most active high yield primary calendar in over two years. While valuations sit at tight levels, yields remain very attractive relative to history, prompting continued strong technical demand for the sector. Mortgage-backed securities (MBS) underperformed for much of the period against a weaker technical backdrop of ongoing quantitative tightening and the possibility of added supply from low coupon sales by banks. However, as the quarter progressed, rate volatility fell and large bank liquidations never materialized, leaving spreads essentially flat.

Corporate

A soft-landing scenario along with some of the highest yields seen in years provides a positive environment for the corporate bond sector. Fundamentals finished the quarter in a position of relative strength: margins and net interest coverage near record highs, balance sheets are in great shape, and the default outlook benign. We overweight the sector while acknowledging that spreads are relatively tight. We express this constructive view in higher-quality issuers with strong cash flows and steady ratings outlooks. While the carry alone will drive attractive returns, we favor intermediate duration positioning that should participate in greater upside as the yield curve normalizes. We continue to overweight the MBS sector where valuations are attractive compared to longer-term averages. Within the space, we prefer seasoned, higher coupon pools that should benefit from the reduced refinancing risk of a shallower Fed rate path that reduces refinancing risk. We also see value in asset backed securities that offer attractive front-end spreads relative to sectors of similar quality.

Outlook

The economy continues to experience formidable momentum, supported by robust consumer spending, a solid labor market, and easing financial conditions. The deflationary trend we saw coming into the year appears to have slowed temporarily, but long-run inflation expectations remain anchored, reflecting market confidence in the Fed’s ability to reach its 2% goal. While a soft landing looks probable, the persistent inversion of the yield curve reminds us that the bond market sees some chance of a pronounced slowdown. The conflicting signals in the data will certainly impact the timing of the Fed’s decision on when to begin easing, setting up a potentially higher-for-longer rate environment.

Read GW&K’s Quarterly Investment Review for the first quarter here.

With contributions from members of our Taxable Bond Team.