Fixed Income Commentary – November 2021

“Short Supply”

Tracy Chapman


Key Takeaways

Most of the action in October for Treasury yields was in the two to ten-year part of the curve, where yields rose from 6 to 25 basis points. As of now, two rate hikes next year are reflected in market yields. Third quarter GDP came in at just 2% (q/q, annualized). Many of the components of this key economic report reflect the disruptions and product shortages that have plagued the recovery from the pandemic, both here and abroad.

October in Review

  • The 10-year Treasury yield finished the month with a yield of 1.55%, up 6 bps month over month.
  • The 2/10 Treasury spread finished the month at 106 bps, flattening from 121 bps in September.
  • Credit had a relatively strong month, up 0.22%, whereas the Intermediate Agg was down 0.43%.


Commentary

Bond yields were in flux in October, pricing in a more aggressive path of Fed rate hikes in the process. As a result, the broad market return was negative for the month as shown in the -0.43% result for the Bloomberg U.S. Intermediate Aggregate Bond Index. The world is in the middle of a transition away from crisis-induced easy monetary policy toward some semblance of normal, and all things considered, the bond market is behaving rather well.

With respect to the yield curve, short term maturities (less than one year) remain anchored near zero since the fed funds rate remains at the zero bound and likely will through at least mid-2022. The real action in October was in the two to tenyear part of the curve, where yields rose from 6 to 25 basis points even as yields fell on the thirty year bond. These rising yields were mostly a reaction to persistent inflation coupled with increasing evidence that the labor market is tighter than the Fed believed earlier this year. Both of these facts make an earlier “lift-off” by the Fed more likely, which is why two rate hikes next year are now reflected in market yields.

Inflation is also behind the hawkish tilt from other central banks, notably the Bank of Canada and the Bank of England. Now that economies are clearly in recovery and following a remarkable series of liquidity injections and quantitative easing measures by central banks, it makes sense to see policymakers finally returning to normal by removing ultra-easy policies, even if very slowly. The supply problems afflicting the global economy are impacting inflation more than most policymakers anticipated and this is finally creating enough worry for them to lean toward tightening policy.

If the current inflation pop means that many companies suddenly have a bit more pricing power, that is certainly a positive take-away from a corporate bond perspective. This bit of pricing power may be one reason behind the benign conditions in the credit sector, where spreads have remained unflappable despite signs that growth has peaked and despite somewhat elevated leverage metrics. Though still early in the earnings reporting cycle, most S&P 500 companies have reported positive revenue and earnings per share surprises for the third quarter, particularly for those with more global exposure. This strong earnings backdrop provides a solid underpinning for corporate spreads to remain firm, although there could be some modest widening should a “risk off” event develop.

With the plethora of supply chain bottlenecks and labor shortages during the quarter, it should not be a surprise that third quarter GDP came in at just 2% (q/q, annualized) following 6.7% in the second quarter. Many of the components of this key economic report reflect the disruptions and product shortages that have plagued the recovery from the pandemic, both here and abroad. Durable goods experienced a sharp drop in consumption, for example, primarily due to auto production which suffered from the shortage of microprocessor chips. Services consumption did not escape the slowdown either, likely due to the hesitancy to engage in in-person services due to rising infection risks.

 

 

Another often-overlooked component of economic growth is tourism, hugely important to states like Hawaii and Florida and industries like retail and transportation. With the ongoing travel restrictions for US entry by foreigners coupled with the easing of restrictions on US residents traveling abroad, the net trade in travel services swung from its usual surplus to a deficit. This seeming detail matters when other major components of economic growth are impeded, and we would expect this to swing back to a surplus now that travel restrictions on foreigners are set to ease up.

The supply chain bottleneck issue leaves us pondering what actions supply chain managers will take going forward. Should there be a desire to maintain higher inventory by a wide swathe of industry, perhaps there will be a smoothing of GDP in the next few quarters as these inventories are acquired. Admittedly this would be a small effect on overall growth, but it’s possible real change like this will develop as the result of the global pandemic. Work patterns will not be the only thing that changes from this epic phenomenon.

Other substantial change is afoot with the burgeoning push toward decarbonization and clean energy, with major impacts for business and consumer sectors expected, but with varying timeframes and effects on the investment front. Utilities will be part of the transition and play a key role in powering electric vehicles and we expect to remain an active investor in corporate and municipal utility bonds. Meanwhile, the energy industry has already begun to migrate toward a less carbonintensive footprint, and we expect oil and gas to remain important parts of the energy mix for many years. Increasing pressure from government and awareness by consumers will likely push companies toward new ways of producing products and services with lower carbon intensity. All of this change is exciting from a growth and investment perspective and will demand prudent, thoughtful, and deliberate study to embrace opportunities for sustainable income.

We will close by wishing our readers a Veteran’s Day full of gratitude and pride as well as a Happy Thanksgiving with family and friends.