The fixed income market experienced a solid rally in the first quarter, rebounding from their worst year on record. Much of the period saw a continuation of the tension that drove trading in 2022: inflation continued to slow, but at a glacial pace; a moribund housing market and downbeat consumer had yet to manifest as a slowdown in spending; and a record pace of rate hikes was unable to cool a stubbornly hot labor market. Investors also struggled to anticipate the Fed’s reaction function amid the various crosscurrents, while Chair Powell’s commentary offered few concrete insights beyond a firm resolve and data dependence. But the narrative shifted abruptly in the final weeks, as signs of systemic instability flared up amid a flurry of bank failures. The implications of this turmoil for financial conditions are not yet evident, but the stress in the banking sector is clearly a complicating factor for both the Fed and the bond market.
The Treasury market posted a strong gain, as elevated macroeconomic uncertainty and rising concerns around financial instability caused rate volatility to spike. Following Powell’s hawkish congressional testimony in early March, there was a brief instant where every tenor of the yield curve was above 4%, as investors capitulated and accepted the Fed’s “higher for longer” policy prescription. But within days, the collapse of Silicon Valley Bank and fears of contagion caused rates to collapse. Various segments of the curve reached new depths of inversion for this cycle, signaling a significant contraction of financial conditions and a dire outlook for the economy. Following the March FOMC meeting, at which rates were once again increased by 25 basis points, Powell acknowledged the potential for ructions in the banking system to tighten policy, but nevertheless, reiterated his belief that the terminal rate has yet to be reached.
Corporate credit spreads traded in a wide range, but ultimately settled close to where they began the year. Even in the immediate aftermath of the bank failures, when spreads gapped out to their wides for the quarter, the risk premia for both investment grade and high yield failed to surpass their 2022 peaks. This relatively benign price action highlights that, away from acute pressures in the banking space, the broader market remains clear of financial distress. The most recent earnings reports from across the industrial space points to a stable, if lackluster, outlook for profitability. The new issue market remains open to borrowers across the quality spectrum. The default rate continues to be subdued and sits at a low level by historical standards. The banking sector was a notable underperformer, of course, but several traditionally cyclical sectors in the consumer, capital goods, and basics sectors saw their spreads tighter on the year. The mortgage-backed securities space slightly lagged similar duration Treasuries. Spreads widened on elevated rate volatility and the possibility that banks could be forced sellers of MBS in response to deposit flight.
The disconnect between the Fed’s Summary of Economic Projections (SEP) and the bond market’s expectations for the path of rate hikes remains at extreme levels. The SEP’s median estimate has the overnight rate at 5.1% at yearend; the bond market, meanwhile, not only assigns low odds to ever achieving that rate, but also reflects two 25 basis-point cuts by that time. Our view is that regardless of how this disconnect is resolved, it is likely to be accompanied by a broad re-steepening of the yield curve.
Our fundamental view of corporate credit remains cautiously constructive, though we find valuations somewhat less compelling. We recognize the various recession signals being sent by the yield curve, economic data, and the Fed’s own projections, so we continue to test our investment theses against downside shocks. Our outlook is also informed by our belief that corporations have come into this challenging environment from a position of greater strength than they have other recent bouts of volatility. This is particularly the case in the high yield space, where the quality of the average issuer is higher, interest expenses are better covered, and the reliance on capital markets is comparatively minimal. The investment grade market, for its part, is similarly well situated, with profitability among large and blue-chip issuers proving resilient despite tightening financial conditions.