The investment grade market was relatively calm in the third quarter, but we are concerned about undercurrents lying beneath the surface. In particular, we feel the dual threats of persistent inflation and a less accommodative Fed have the potential to impact pricing over the near to medium term.
U.S. Treasuries ended their 4-month streak of positive returns and falling yields in August. Intermediate maturity yields rose more than shorter and longer maturities, as the market began to see through the impact of the Delta variant and focus more on the Federal Reserve’s plan to scale back their bond buying program.
Longer term Treasury yields fell for a fourth consecutive month in July, as concerns around the resurgence of coronavirus weighed on forecasts for continued economic growth. Agency MBS underperformed investment grade corporates and Treasuries. While some inflation metrics set generational highs, and other economic data indicated a continued recovery, investors were focused on the potential impact of viral spread.
Despite a strengthening economy in the second quarter, investors were highly focused on the Federal Reserve’s response to the recent spike in inflation data.
Following the June Federal Open Market Committee (FOMC) meeting, the Treasury curve flattened as the market reacted to a more aggressive hiking schedule than previously expected. Risk continued to perform well as investment grade (IG) corporates outperformed again and tightened through levels not seen since 2018. Economic data continues to improve showing the reopening remains on track, but investors remain focused on elevated levels of inflation.
Treasury yields fell again in May and credit spreads approached recent tights as the virus continued to recede, allowing the reopening of the economy to progress. Economic data was noisy this month, largely due to base effects, but confirms the ongoing trend of renewed growth and signs of inflation.
Investors aggressively sold off Treasuries in the first quarter in favor of risk assets. We think this is likely to continue as the economy strengthens and inflationary pressures build, and we are maintaining a defensive duration profile to protect against rising rates.
Treasury yields rocketed higher in February, with the move again concentrated in longer maturities. Volatility spiked as liquidity dried up in the Treasury market, especially after a very weak 7-year auction that briefly pushed 10-year Treasury yields to 1.60%. The news flow was largely the same direction: an improving economy, increased vaccine rollout with deaths and hospitalizations turning sharply lower, and a continued march toward a substantial fiscal stimulus plan.
Treasury yields continued to march higher in January, with the move again concentrated in longer maturities. Mortgage spreads tightened slightly, while corporate bond spreads were mostly mixed. The market remains stuck between the push/pull of the prospect for greater fiscal stimulus and ongoing vaccine rollout versus continued lockdowns and the greatest one-month mortality rate since the pandemic began nearly a year ago.
Markets continued their recovery during the 3rd quarter, but the narrative transitioned from concerns about the pandemic to the U.S. election – a trend that we expect to continue in October. The outcome will likely have a material impact on both fiscal stimulus policies and Treasury yields.
While we appear to have averted the worst pandemic outcomes so far, a resurgence in recently reopened states shows that we are not yet out of the woods. In our view, the economy will not fully recover until there is a vaccine or a reliable treatment.
2019 proved to be a very strong year for almost all financial assets, as equities and bonds rallied in tandem. The Federal Reserve (the Fed) was compelled to play defense against a weaker global economy (particularly in Europe) and continued uncertainty related to the trade dispute between the U.S. and China.
The fixed income market benefited in the third quarter as both global growth fears and the trade dispute continued to drive uncertainty in financial markets. With Europe remaining in an economic rut and China showing signs of slowing from the protracted trade conflict, investors sought the safety of U.S. Treasuries, pushing up prices and reducing yields.
Fixed income markets will be hard pressed for an encore performance of the second quarter. Risk assets of all flavors rallied in conjunction with Treasury yields falling – whether this is causal or simply concurrent remains to be seen.
Seizing on the success the equity market had in forcing Federal Reserve (“Fed”) chairman Powell’s hand in January 2019, the bond market decided to take its own swing at dictating Fed policy.