April Showers Bring May Flowers
Range-bound is an apt description for the bond market in April. Bond yields for most points on the yield curve barely moved even as markets remained on guard for further fallout from the banking developments in March. First quarter earnings reports provided some assurance that the contagion from the bank crisis has been held in check. However, the report for First Republic Bank renewed market concern, resulting in regulators closing it down on the last weekend of the month. JP Morgan will acquire most of the institution in a similar risk-sharing deal with the FDIC as the one for Silicon Valley Bank.
The only noteworthy shift in bond market yields occurred in the very front end of the yield curve in advance of the debt ceiling spectacle set to unfold over the next few months. The yield of one month Treasury Bills declined by 32 basis points to 4.09%. Meanwhile, three and six month Bill yields remain right around 5%, which reflects the level of fed funds as well as the uncertainty around the negotiations to avoid a payment delay or default. For the month, the total return of the broad market represented by the Barclays U.S. Intermediate Aggregate Index was 0.58%. Meanwhile, the total return for the Barclays Municipal Index was -0.23%.
Subsequent to month end, the Fed raised rates once again by 25 basis points at the May 3 FOMC meeting. This development brought the fed funds rate to 5.00%-5.25% and could prove to be the last tightening action of the cycle. It is likely the Fed will now pause so members can better gauge the effects of the collective actions to date, although Chair Powell’s comments did not explicitly acknowledge that a pause is now certain.
Beyond this latest failure of First Republic Bank, the repercussions from the bank crisis are continuing and could result in a variety of negative consequences in the months ahead. One repercussion is the decline in bank deposits at smaller institutions in favor of the “too big to fail” variety. Analysts at Barclays report that industry-wide deposits dropped by $350B (2%) over a 3-week span in March (post the failures of Silicon Valley Bank and Signature Bank) and have partially recovered since then. Interpreting these declines was made a bit more challenging due to the usual withdrawals that occur around the mid-April annual tax filing deadline, but the trend does seem to be contained for now.
Another outcome could be tighter lending standards, particularly at smaller banks, which is where the bulk of commercial real estate (CRE) loans reside (67% by volume according to TD Securities). CRE property prices have fallen by 15% over the last year due to such factors as higher interest rates, expectations for recession, and the work-from-home trend resulting in less demand for office space. If CRE becomes even more difficult to finance due to less appetite from banks and other institutional lenders, loan defaults could rise which would put more pressure on bank capital ratios. Current delinquencies on CRE from the CMBS market appear reasonable but are on the rise. Performance of loans will partly be determined by the underwriting quality but geographic factors, among other things, will also play a role. It should also be noted that CRE loans can be extended by lenders which can provide breathing room for borrowers who are current on loans.
Finally, the just-released report from the FDIC is recommending an increase in the insured deposit limit for business accounts, which means the $250,000 limit may now have more flexibility depending on the type of account. We believe other changes to the deposit system may also emerge.
Sector performance in April was benign: corporate bond spreads remained within 3 basis points of their starting point which led to modest outperformance compared to similar-duration Treasuries. MBS spreads remain near the wide end of the twelve month range and demand is tepid, perhaps from some overhang due to the liquidation of the Silicon Valley Bank portfolio which began recently. Their performance was slightly behind similar-duration Treasuries. Finally, municipal bonds were modestly weaker during the month, perhaps simply a minor correction from rich valuations.
Economic data during the month provided fodder for optimists and pessimists alike. On the one hand, both ISM Surveys (Manufacturing and Services) declined, including the employment component and the more forward-looking new orders component. On the other hand, the labor report reflected a decent gain of 236K for non-farm payrolls and an increase in the labor force participation rate for the fourth consecutive month. The labor market, admittedly a lagging indicator, remains very firm and reflects slowing (but not collapsing) hiring activity. Perhaps the fiscal policy actions of last year such as the Inflation Reduction Act are helping provide some cushion. Indeed, McKinsey reports that climate-related private-market equity investments reached $196B in 2022, a nearly threefold increase from 2019. The expanding labor supply is particularly encouraging since it may help reduce wage inflation at this critical time. Although wage growth remains higher than prevailing pre-pandemic levels, the 3-month annualized rate of growth for average hourly earnings is down to 3.2%.
With the debt ceiling drama beginning to take center stage and mounting evidence that the rate hikes are slowing the economy, a Fed pause after the May hike does appear likely. However, if inflation does not return to the 2% area (after a reasonable time has passed and sufficient data has been observed), the Fed will have little choice but to raise rates yet again.
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.
