Fixed income markets rebounded solidly in the second quarter following their worst selloff in decades. The most prominent catalyst behind the first quarter rout—the threat of sharply faster economic growth and elevated inflation—proved far less menacing in light of lackluster data and a less dovish Federal Reserve. In addition to the overhang of COVID-19, including fears of new variants and the elusiveness of herd immunity, signs began to emerge that the pace of the recovery had peaked. Nonfarm payrolls posted successive disappointments, the manufacturing resurgence stalled, and retail sales slipped. Some of the more sensational commodity price spikes began to roll over as well, casting further doubt over the persistence of recent inflationary pressures. None of this suggests that the recovery is off track, but the bond market’s stubborn resilience points to a marked revision of the timeframe for normalization.
The Treasury sector experienced a modest retracement after its first quarter decline. The yield curve flattened significantly as investors grappled with decelerating growth, the prospect of less accommodative monetary policy, and less ambitious fiscal stimulus. The most conspicuous driver of the move was the collapse in real yields, which tracked the growing skepticism about the momentum and durability of the ongoing recovery. Inflation breakevens played a smaller role, briefly climbing to their highest level of the last decade before retreating back to flat for the quarter. The most meaningful development, of course, was the Fed’s June meeting and subsequent press conference from Chair Powell. The upward revision of estimates for the overnight rate in 2023 was perceived by the market as having a decidedly hawkish tilt, and even though Powell urged against taking the “dots” too seriously, the ensuing price action was fierce. Rates at the front end shifted higher, registering a faster pace of hikes in accordance with the Fed’s projections, while intermediate and long rates rallied in a reflection of just how fragile investors believe the recovery is. Mortgages underperformed Treasuries, despite slower prepayment speeds and lower rate volatility, as focus shifted to the uncertainty around the eventual tapering of the Fed’s buying.
Corporate bonds tightened for a fifth straight quarter. Credit spreads compressed to levels last seen prior to the Great Financial Crisis, as robust appetite for yield and benign financial conditions supported demand for the sector. Corporations guided to healthy revenue growth and showed few signs that input costs or supply chain disruptions would meaningfully impact margins. They also continued to take full advantage of wide open primary markets to raise liquidity, extend maturities, and reduce interest expense. Evidence of financial distress became increasingly scarce, even among the riskiest segments of the credit market, and the default pipeline was virtually nonexistent. Investors’ sanguine attitude toward credit risk was most strikingly on display in the speculative grade market, which saw the sector’s yield end the quarter at a record low.
The question of whether inflation is structural or merely transitory is set to remain a dominant driver of rates in the near term. Investors are likely to consider economic readings primarily through the lens of their impact on Fed policy, with significant implications for both the level and shape of the yield curve. The range-bound trading pattern of the last several months reflects how little conviction there has been on either side of the argument. With the market expecting four quarter-point hikes by the end of 2023 and the Fed projecting two, the bias across the curve certainly seems to be to the upside. But the potential for volatility along the way and the ultimate slope of the curve complicate the question of how best to position in advance.
We remain constructive on corporate credit and believe it continues to offer the best value in the fixed income market. Recent spread tightening does little to dim the sector’s appeal, given its favorable profit outlook and broadly improved financial profile. Additionally, relative to the Treasury sector, corporates offer a buffer against rising interest rates and the opportunity to earn excess returns amid the unfolding recovery. We also continue to see value in the higher-quality segments of the high yield market, where spreads still sit wide of historical lows and many companies are demonstrating discipline in their efforts to continue improving their credit profiles after the challenges of the last year. We have a neutral view of the mortgage sector due to middling valuations and uncertainty with respect to the fate of the Fed’s buying in the sector in the months ahead.