Fixed Income Commentary – July 2021

“Higher Power”

Coldplay


Key Takeaways

The Fed’s rhetoric shifted in June as Powell’s post-FOMC comments suggested the removal of some of the stimulus measures that have been in place. There is a bit more concern around the trajectory of inflation. Several FOMC members now see a rate hike in 2022 as more likely, and two rate hikes are expected in 2023. Spreads continued to tighten due to strong demand for non-government bonds.

June in Review

  • The 10-year Treasury yield was 1.47% at month-end, down 12bps month over month.
  • MBS had its second consecutive negative month in a row, down 0.04%.
  • Credit had a very strong month as demand continues to be strong, up 1.50%.

 


Commentary

Bond yields were impacted by Fed Chair Powell’s comments in June, with longer term yields (7yr and longer) declining and shorter term yields rising a bit.  This action is referred to as a “flattening” in the shape of the yield curve since the difference between short and long points is narrower than before.  Powell’s comments came after the FOMC meeting on June 16 which acknowledged some discussion by the Committee on inflation and the process of removing some of the stimulus measures now in place.  These changes led to a total return of 0.04% for the Bloomberg Barclays Intermediate Aggregate Index.

The Fed is sometimes viewed as the “higher power” by many and is the subject of much speculation on its conduct of monetary policy.  Many are wondering if the higher inflation of recent months has changed any thinking at the FOMC regarding their expectation that inflation pressure will be transitory rather than persistent.  After last year’s comments — the famous “not even talking about talking about” raising rates or reducing stimulus — Powell did acknowledge that such a discussion has begun and suggested that phrase be retired.

The FOMC also released a revised set of expectations on inflation and the “dot plot” which is each member’s current prediction for the fed funds rate at various points in the future.  Several additional FOMC members now see a rate hike in 2022 as more likely, and two rate hikes are anticipated in 2023.  These communications are helpful in assessing how the current FOMC views these issues based on what they know today and what they expect, but both the makeup of the Committee and the future are, of course, subject to change.  The take-away: The Fed is a bit more concerned about the trajectory of inflation and believes that the breadth and pace of the recovery have been sufficient to allow for the markets to now absorb this subtle, hawkish shift.

The flattening action in June was notable since it validates the bond market’s acceptance, broadly speaking, of the Fed’s narrative of transitory inflation.  In past cycles, the bond market has often had the role of pushing the Fed into action, so the benign market is a sign that the Fed’s credibility remains intact.  Since several Fed officials have now acknowledged that inflation has been somewhat more elevated than expected and the FOMC has reined in the timeframe for its easy money stance to begin changing, the market is clearly giving the Fed the benefit of the doubt.  This should come as no surprise since inflation has not hit the Fed’s target of 2% for years and many of the factors responsible for that trend remain in place.  It should also come as no surprise that the Fed would not want to lose the long-term war on inflation that began with Paul Volker’s tough medicine back in 1979.  Should the current inflationary trend display any signs of entrenchment or escalation, we believe the Committee would come into line pretty quickly and decisively to change course, even if it resulted in some degree of negative market reaction.

In other developments last month, risk spreads continued to tighten, or narrow, due to strong demand from the investment community for non-government bonds.  Investor inflows into the municipal sector have continued at a torrid pace and supply of municipal bonds, although sizable, simply has not kept up, so valuations have improved once again, albeit at a slower pace.  This trend can be seen most clearly when observing the high yield sector which has chalked up a total return of over 6% in just six months.

 

Corporate bond yield spreads also narrowed further in June since investors can point to improving earnings and a general absence of major ratings downgrades of key investment grade issuers.  With this benign credit environment firmly in place amidst an improving economy, there do not appear to be any major impediments for corporate bond spreads to continue narrowing.  A quick reminder is in order here: narrower yield spreads relative to Treasuries, all else equal, lead to higher prices for non-government bonds.  Investors refer to these higher returns as “excess returns” over and above Treasuries.  Of course, the reverse is also true: wider yield spreads relative to Treasuries, all else equal, lead to lower prices, and the resulting lower total returns are referred to as negative excess returns.

The pandemic caused most non-government bond spreads to widen sharply but briefly which led to negative excess returns in the first quarter of 2020.  Spreads have been tightening fairly steadily since then as monetary and fiscal policy measures were introduced and, more recently, as the economic recovery gained momentum.  Barring any major disruptions or idiosyncratic events, it seems likely corporate bonds will remain a good source of yield for conservative investors for the foreseeable future, but selectivity remains paramount.

Agency MBS, on the other hand, remain priced at rich valuations due in part to the steady pace of buying by the Fed (banks have also been buyers due to tepid loan demand).  This program is one facet of the Fed’s extraordinary measures to provide stimulus to the markets but is arguably no longer needed since mortgage rates are quite low and the mortgage market is functioning smoothly.  Rich valuations are the primary reason for negative returns for this sector in June, although the changes in the yield curve were also a factor.  If investors do not find yields compelling, they avoid adding agency MBS in favor of other types of bonds, so valuations are left range-bound rather than moving tighter.

With the economic recovery proceeding nicely, we are sanguine about the prospects for more of the same: a range-bound Treasury market should allow for decent yield to continue to be earned by bond investors.  We want to emphasize, however, that complacency is not setting in here at Maple.  We have managed through booms and busts and have seen long periods of calm markets as well as periods of extreme illiquidity and angst.  We are also of the opinion that tomorrow’s bad loans will be made during good times such as these, and we will remain diligent in selecting bonds that will deliver the results you have come to expect from Maple Capital.