GW&K Taxable Bond Market Commentary –
2Q 2024
After an unsteady start to the quarter that saw upside surprises to both growth and inflation, evidence emerged that the lagged effects of tight monetary policy might finally be working. A stream of high frequency data prints painted a picture of a robust economy that was downshifting to a slower-growth trajectory. Signs of progress on inflation appeared as the Fed’s favored core inflation gauge slowed to 2.6% year-over-year, its lowest point since March of 2021. In the absence of significant weakening in the labor market, the Fed indicated they would require several more months of similar data before they would feel comfortable easing monetary policy. With that backdrop, the FOMC held rates steady for a seventh straight meeting, and in a surprisingly hawkish move, dialed back rate cut expectations for 2024 from the three signaled in March to only one. Slightly more optimistic that the upside risks to growth and inflation were fading, the market projected the Fed would push through two quarter point cuts this year, with the first fully priced for November.
Interest Rates on a Roller Coaster
Mixed signals in the economic data drove interest rates in a roller coaster pattern. In the opening weeks of April, rates surged on stronger growth and elevated inflation data, which made it increasingly difficult to argue that the hot prints in the first quarter were an aberration. Shortly thereafter, rates retraced much of that selloff as a package of weaker economic data, including benign inflation readings, bolstered the case for lower rates. Treasury yields finished the quarter 13-22 bps higher, with the longer end leading the selloff. Meanwhile, the ongoing inversion of the 2/10’s segment marked a record continuous 23 months, an unrelenting signal that the bond market still predicts an eventual recession. If the economy does manage a soft landing, this will go down as the biggest false signal in history.
Corporate Spreads
Unable to keep pace with the significant rate rally in the latter part of the quarter, investment grade and high yield corporate spreads widened slightly by 4 bps and 10 bps, respectively. Despite the modest movement, spreads are still within a few basis points of their post-GFC tights. The sector is supported by continued economic resilience, strong earnings, and appealing all-in yields. The stable spread performance is noteworthy against an environment of heavy investment grade issuance and the most active high yield calendar in two years.
MBS Spreads Attractive
Agency mortgage-backed securities continued to trade directionally with rates as 30-year nominal spreads widened a modest 10 bps. Spreads remain attractive from a historical standpoint and relative to corporate bonds. Year-to-date, higher coupons have generally outperformed Treasuries due in large part to their higher carry. Lower coupons lagged due to expectations for technical selling pressures from regional bank portfolio reallocations. Asset-backed securities outperformed the broader MBS market due to stable spreads and their shorter duration profile during a rate selloff.
With the first rate cut priced a few months away, we have likely seen the peak in interest rates for this cycle. On the other hand, with the Fed signaling a data-dependent position, we think it would be difficult for rates to rally much further from here and look for Treasury yields to remain rangebound throughout the summer.
The current environment of healthy underlying growth, downshifting inflation, and a supportive Fed provides a favorable backdrop for carry-seeking behavior. Spreads remain tight but are supported by solid credit fundamentals and some of the highest yields in years.
Outlook
After multiple quarters of conflicting economic data, there are formidable signs that the effects of higher-for-longer interest rates may finally slow economic activity enough to remove further upside risks to inflation. Recent data suggests the long resilient consumer is finally pulling back on spending, and the labor market is cooling toward pre-pandemic levels. Pricing pressures are slowly easing toward the Fed’s 2% target, yet the demand side effects on services and housing inflation should keep the Fed data dependent and hesitant to cut rates in the near term. As growth downshifts to a more modest level, we believe the biggest threat to the economy is the Fed will wait too long before easing, risking a potential downturn.
Read GW&K’s full Quarterly Investment Review for the second quarter here.
With contributions from members of our Taxable Bond Team.