Living on the Edge
There were two overarching themes that drove bond market performance in May — the debt ceiling and the possibility of a Fed pause in June. The former issue was finally settled just as the month closed out, while the latter is now the dominant theme until June 14 when the next FOMC meeting concludes. During the month, most bond yields rose by 25-50 basis points, leaving total returns in negative territory for the period. Total returns for the Bloomberg U.S. Intermediate Aggregate Index and the Bloomberg Municipal Index were -0.73% and -0.87% respectively.
A great deal of time and energy was consumed by the debt ceiling issue and the entire process is uncomfortable for most Americans. It’s also uncomfortable for the rating agencies who opine on the credit quality of the US. It came as little surprise that Fitch, one of the three main independent rating agencies, placed its AAA rating of the U.S. on negative watch. S&P already took the radical step of downgrading the U.S. to AA+ after a similar debt ceiling drama in 2011. Fitch cited many issues but prominent among them were the governance challenges from contested elections, the brinksmanship over the debt ceiling, and the failure to address fiscal challenges.
The media’s fixation on the debt ceiling drama seemed to add fuel to the fire by incentivizing both sides to delay any agreement and keep the attention level high. With political parties as divided as ever, the chances of an early agreement were low to begin with. Both sides were aware that taking a tough stance against the opposing party would play well with their base, so it seemed obvious that a deal would only get struck at the proverbial “eleventh hour” to leave no time for debate.
Most defaults occur when a company files for bankruptcy and seeks debt relief or outright dissolution in the process. If the U.S. did in fact default on its debt, it would be a far different situation in which a payment delay would occur, possibly accompanied by rating downgrades and other market disruptions, but ultimate payment would not be in question. To our mind, there has been far too much made of this entire situation and it has been nothing more than an embarrassment and a distraction.
Economic data in May proved more resilient once again, a recurring theme this year: new home sales, nonfarm payrolls, durable goods orders, and the core component of retail sales were all higher than expected. All these reports added to the sense that the Fed would be inclined to keep the “terminal rate” unchanged for an extended period of time, and the core PCE inflation report only added to that sentiment. The strength of these and other reports led some forecasts to build in another rate hike at the June 14 FOMC meeting (or the following one in July). It is worth mentioning that monetary policy works with a lagged effect and after the big increase in borrowing costs last year, we still believe economic growth is more likely to slow as the year progresses.
The resilience of the consumer this year has surprised many. One partial explanation may be the durable monthly savings many were able to achieve by refinancing during the 2020-2022 period when mortgage rates plummeted. This expense reduction enabled consumers to shift to higher savings or spending on other goods and services. At the same time, those relying on interest income for monthly expenses are now enjoying higher income thanks to higher interest rates.
Inflation has been slowing but is still too high and the longer it remains meaningfully above the 2% goal, the risk rises that it becomes embedded in the consumer and business psyche. “Recency bias” (the tendency to overemphasize the importance of recent experiences or information) could convince consumers that high inflation will persist. We do believe there are elements of the inflation story that could remain sticky, such as shelter and discretionary categories like travel and food away from home.
China’s lack of pep in its recovery from the pandemic is gaining attention and worth noting since its growth has been such an important part of global growth for the last few decades. One implication already being seen is oil’s price retreat ( which is certainly favorable for U.S. consumers). However, we continue to have concerns that in the long term, China’s economic miracle may no longer be the reliable growth engine that it was and a whole host of consequences may be felt in the coming decades.
In terms of sector performance, corporate bonds in the ten year and under part of the curve performed marginally better than Treasuries, while MBS and municipal bonds turned in a solid month.
In closing, another Fed rate hike in June or July is certainly a real possibility given the economic resilience and the risks to inflation which remain skewed to the upside. Nevertheless, the tightening campaign is closer to the end than the beginning and there is reason to believe that a recession could still be avoided. With that, we wish you all a pleasant summer.
Important Disclosures
Maple Capital Management, Inc. (MCM) is an independent SEC Registered Investment Advisor with offices in Montpelier, Vermont and Atlanta, Georgia.
This commentary reflects the views of MCM and should not be considered to be investment or financial advice. MCM does not warranty these views and will not update this communication after the date of publication. Any mention of specific securities is done for illustrative purposes and the securities mentioned may or may not be held in client accounts. No assumption or assurance should be taken that securities mentioned will be safe or profitable investments. Past performance is not indicative of future results
For further information, please contact Steven Killoran at 1-802-229-2838 or at [email protected]. For further information about Maple Capital, including a copy of our informational brochure, please visit our website at www.maplecapital.com.
Index Definitions
The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
The Bloomberg Intermediate US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market with less than 10 years to maturity. The securitized sector is wholly inluded. The index includes Treasuries, government-related and corporate securities, MBS, ABS and CMBS..
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.
The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
The Bloomberg US Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded.
The Bloomberg U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
