The fixed income market posted a small loss in the second quarter, giving back a portion of the banking crisis-inspired rally that occurred in the closing days of March. Sentiment was cautious at the outset and investors sought haven assets on the possibility of contagion in the financial sector. But as it became clear that fallout from the failure of several regional lenders was likely to be contained, attention returned to the underlying strength of the economy and the stubborn persistence of inflation. The labor market gave only the slightest indications of softening, the buoyant housing sector continued to defy higher mortgage rates, and consumer spending once again proved irrepressible. Inflation showed limited progress on its path lower, plateauing at a level solidly above the Fed’s 2% target. Against this backdrop, the FOMC endeavored to maintain restrictive financial conditions by raising rates and providing hawkish guidance. There has nevertheless been scant evidence of the Fed’s success in curbing aggregate demand away from some narrow segments of the commercial real estate and consumer finance markets.
The Treasury market was under pressure throughout the quarter. With stress in the banking sector receding and risk aversion dissipating, rates across the curve shifted higher. The front end underperformed as the Fed raised the overnight rate by 25 basis points in May and then, despite choosing to pause in June, increased the projected terminal rate by 50 basis points. The movement in longer rates was comparatively staid, causing several key segments of the yield curve to retest levels of inversion last seen just before the first bank collapsed in March. Similarly, real yields once again approached post-Global Financial Crisis (GFC) highs, suggesting a resumption of a broader tightening trend. Meanwhile, inflation breakevens traded in a remarkably tight range, reflecting the market’s unwavering confidence that the Fed will ultimately achieve its goal.
Corporate credit continued to signal a benign outlook for financial distress. Spreads in both investment grade and high yield were tighter on the quarter and substantially inside of wides reached earlier this year. First-quarter earnings showed revenues and margins coming in ahead of relatively downbeat expectations, lending support to the narrative that any downturn in profits is likely to be short and shallow. New issuance has been brisk and access to capital has been ready, with higher rates doing little to dissuade borrowers from coming to market.
Mortgage-backed securities (MBS) also produced positive excess returns. The FDIC’s liquidation of failed lenders’ balance sheets was met with robust buyside participation, while nominal spreads at post-GFC wides created a compelling relative value proposition for asset allocators. Sentiment was further boosted by slower prepayment speeds, declining rate volatility and the Fed’s evident reluctance to begin selling its MBS.
After an extended period of disconnect between the Fed’s forward guidance and the market’s expectations, the Fed has finally persuaded bond investors to follow its lead. The market has now completely priced out what at one point was an expectation of as many as four cuts by the end of 2023, with rates expected to be at or above current levels until mid-2024. Now investors must grapple with the lagged effects of hikes that have already occurred, the potential for yet more tightening and macroeconomic data that will have exaggerated influence as we approach this cycle’s end.
Our view of corporate credit remains somewhat cautious, particularly as the cycle advances and spreads sit inside their long-term averages. We recognize that companies have been successful limiting their sensitivity to rising rates by extending maturities and building liquidity. We also appreciate how resilient profit margins have been despite tightening financial conditions and fears of a slowdown.
The consumer space stands out as an area where we’re being especially selective, as the impulse from last year’s fiscal stimulus fades and consumer savings dwindle. At the same time, we are finding attractive opportunities among blue chip borrowers, which continue to trade at attractive yields. We are also more upbeat on MBS in light of recent spread widening and following the removal of the overhang from bank wind-downs.
Read GW&K’s full Quarterly Investment Review for the second quarter here.
With contributions from members of our Taxable Bond Team