The fixed income market posted a significant loss in the third quarter that more than offset the gains achieved in the first half of the year. The higher-for-longer Fed narrative increasingly took center stage, driven by a surprisingly resilient economy, surging oil prices, and inflation that persisted well above the Fed’s 2% target. While there were subtle signs that the labor market and consumer credit metrics might be softening, the unemployment rate remained near cycle lows and the consumer continued to spend robustly. The undeniably strong cadence of the economy left economists upgrading their third-quarter GDP growth estimates and recharging optimism for a soft landing. Fed officials held rates steady at the September FOMC meeting, but thwarted hopes for a pivot by signaling the possibility of one more hike this year and projecting less easing in 2024/2025.
In addition to the Fed’s more aggressive outlook, a repricing of recession risk and the potential feed-through to inflation from surging oil prices, the market also endured an unexpected downgrade of US government debt. The negative rating action focused attention on the longer-term implications of persistent fiscal deficits and the need for increased Treasury supply, especially in longer-maturity bonds. The Treasury market responded to this toxic combination with a relentless move higher in rates across the yield curve, with 2-year and 10-year maturities hitting their highest levels since 2007. Ten-year real yields pushed through 2% for the first time since 2009, reflecting tighter financial conditions and stronger economic growth. At the same time, breakeven inflation expectations were relatively contained, echoing the market’s confidence the Fed will achieve its inflation target. While still inverted, the 2s-10s curve experienced a significant bear steepening, narrowing its negative slope by approximately half.
Corporate credit continued to reflect a benign economic outlook. Strong fundamentals and positive technicals kept spreads essentially unchanged on the quarter and well below their longer-term averages. The stability in spreads was a triumph against a sharp pickup in new issuance, as companies rushed to get ahead of the final stages of the Fed’s rate-hiking campaign and begin chipping away at the rapidly approaching wall of maturities. The outsized issuance garnered robust investor demand, with higher all-in yields seen as a significant cushion to forward returns.
Mortgage-backed securities spreads widened marginally against heightened rate volatility, a steepening yield curve, and a weak technical backdrop amid lower bank and money-manager demand.
We witnessed a mind-numbing period where the market’s expectations for multiple interest rate cuts this year were in complete opposition to the Fed’s well telegraphed guidance for rate hikes. But now that there is little doubt persistently high inflation is the Fed’s predominant concern, the market has begun to reflect a greater acceptance of restrictive policy going forward. The higher-for-longer message drove 10-year yields to within striking distance of 5% and the bond market toward a potential third straight annual loss.
It is uncertain whether this higher level of yields represents the new normal or a rate move gone too far. While the economy continues to exhibit surprising strength, formidable headwinds lie ahead, including tighter credit conditions, dwindling excess consumer savings, slowing global growth, and rising energy prices. These economic challenges could shift the narrative from an economy that is impervious to rapid rate hikes to one that is susceptible to below-trend growth next year.
The swift rise in rates to multi-year highs makes the value proposition for bonds more compelling. These higher levels of yields can provide a significant cushion should rates continue to rise and are often a good indicator of forward returns. We continue to favor higher quality intermediate-duration bonds. Locking in these maturities diminishes reinvestment risk while still offering the potential for significant price appreciation when the Fed finally signals a pivot. We remain underweight the long end of the yield curve, which is most vulnerable to losses in this higher-for-longer regime.
Read GW&K’s full Quarterly Investment Review for the third quarter here.
With contributions from members of our Taxable Bond Team