Weekly Fixed Income Commentary: Favorable inflation data send Treasury rates lower
Weekly fixed income update highlights
- Total returns were positive for Treasuries, agencies, investment grade and high yield corporates, taxable munis, MBS, ABS, preferreds, convertibles, senior loans and emerging markets.
- Municipal bond yields declined. New issue supply was light at $4.5B, with outflows of -$2.5B. This week’s new issuance should rise to $8.5B.
U.S. Treasury yields fell sharply after October inflation numbers came in lower than expected for only the third time since the start of 2021. The market responded by pricing a less hawkish path for U.S. Federal Reserve policy rates in 2023.
Watchlist
- 10-year Treasury yields fell sharply across the curve last week.
- Spread assets gained amid the drop in rates.
- Net-negative supply should provide some support to municipal bonds.
Investment views
Accommodative interest rate policy remains a key market support. While investors continue to focus on more hawkish Fed policy, overall rates are likely to remain relatively low even after several rate hikes.
The underlying growth outlook remains healthy, as consumers have strong balance sheets, businesses are reinvesting and Covid recedes. This should keep defaults low.
Treasury yields have risen this year, but the pace of long-term increases should remain relatively modest.
We favor a risk-on stance, focused on credits with durable free cash flow and solid balance sheets across a wide range of sectors. Mid-quality rating segments appear particularly attractive. Essential service municipal bonds also look compelling.
Key risks
- Inflation fails to moderate as expected, negatively affecting asset values.
- Policymakers remove accommodation too rapidly, undermining the global economic expansion.
- The Russia/Ukraine conflict continues to escalate.
- Covid-19 cases increase, or new variants emerge.
Demand returns to high yield corporate funds
U.S. Treasury yields rallied substantially after October inflation numbers wound up being lower than expected. Headline prices rose 7.7% year-over-year, -0.2 percentage points less than forecasted. That is only the third time since the start of 2021 that inflation has come in lower than anticipated. Core prices also moderated, to 6.3% year-over-year. Both continue to run high, but the trend has moved toward lower inflation. The market responded by pricing a less hawkish path for Fed policy rates, fully removing an entire 25 basis point (bps) hike from 2023 pricing. Two-year yields accordingly fell -33 bps, while 10-year yields fell -35 bps.
Investment grade bonds rallied, returning 2.62% for the week and beating similar-duration Treasuries by 40 bps. At the index level, yields were down -39 bps, while spreads tightened -5 bps. That was the biggest decline in yields since spring 2020. The most liquid names led the rally, as accounts generally scrambled to add risk after the soft CPI report. Before the inflation data, supply had been heavy, with $46 billion of new issuance, comfortably exceeding expectations for less than $20 billion. At the same time, outflows continued at -$1.7 billion, though the post-CPI euphoria vastly outweighed the technical headwinds from supply and outflows.
High yield corporates also gained, returning 1.19% for the week, though the asset class lagged similar-duration Treasuries by -32 bps. As in high grade markets, new issuance picked up, with $6 billion of new deals pricing for the week. Demand returned as well at $1.3 billion. Loan funds continued their recent strong performance, returning 0.60%, despite a -$582 million outflow.
Emerging markets outperformed, rallying 2.41% and outpacing similar-duration Treasuries by 41 bps. The soft CPI number sparked a substantial selloff in the dollar, which weakened -3.9%. The weaker dollar has cascading benefits for emerging markets economies, which benefit from lower funding costs and less pressure on external accounts. Sovereign spreads tightened -14 bps, with high yield sovereigns leading the way, -23 bps tighter, after lagging for most of this year.
The municipal market rallies
Municipal and Treasury bond yields rallied after the CPI report was published Thursday morning. Short-term muni yields closed 8 bps lower, while long-term rates ended down 18 bps. The municipal bond new issue calendar remained light. While fund outflows continued, tax-exempt exchange-traded funds and money market funds both saw positive flows.
Thursday’s CPI report showed inflation was beginning to subside, suggesting that the Fed may be closer to ending its short-term rate hikes. The 10- year Treasury bond rallied 29 bps on Thursday, and the curve remains inverted, meaning many investors expect long-term rates will be lower in 2023.
The municipal market is alive and well. The MMD 10-year yield declined 12 bps on Thursday. Strong interest in tax-exempt bonds continues at these high yields. However, we expect continued volatility in munis through the end of the year due to an outsized amount of tax loss trading. Looking ahead, we believe 2023 should be a good year for tax-exempt bonds.
The Florida Department of Transportation issued $192 million turnpike revenue bonds (rated Aa2/AA). The deal included 5% coupon bonds due in 2047 that came at a yield of 4.57%. Those bonds traded in the secondary market at 4.26%.
High yield municipal bond yields rallied 17 bps on average last week, lagging high grade munis and 10-year Treasuries. Several events reminded investors of the underlying fundamental strength supporting this long-term value. Chicago was upgraded by Moody’s, shedding its below investment-grade rating. California announced a tender offer for its tobacco bonds, recognizing the irrational prices bonds are currently trading. American Dream announced it restructured its construction bank debt while strengthening the mechanism to replenish reserve funds.
The weaker dollar has cascading benefits for emerging markets economies.
In focus: Interpreting an inverted Treasury curve
As inflation has continued to surprise to the upside this year, markets have ratcheted up expectations for Fed rate hikes. This has led the Treasury yield curve to flatten and invert more deeply.
The 2-year/10-year curve declined to -57 bps earlier this month, from a positive sloping level of 77 bps at the start of the year. Even after the October CPI report came in lower than expected, the curve remains inverted.
Inverted yield curves are one of the best predictors of economic recession. We closely monitor the 2-year/10-year curve, the 3-month/10-year curve and the nearterm forward spread. The latter refers to the spread between 3-month rates and the 3-month rate 18 months forward, a measure that Fed Chair Powell has cited in the past.
For the first time since August 2019, all three curves are inverted. Before 2019, the last two times that all three curves were simultaneously inverted were in July 2007 and August 2000. While the 2019 episode was interrupted by the Covid recession, the prior two instances both preceded U.S. recessions by around six months.
Our models suggest a roughly two-in-three chance that a U.S. recession occurs in the next 12 months, and nearly 90% chance that one will occur in the next 24 months. These models do not specify the depth, severity or length of a recession, and there are good reasons to expect less economic and market pain this time than in prior recessions.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 11 Nov 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 09 Nov 2022.
Any reference to credit ratings refers to the highest rating given by one of the following national rating agencies: S&P, Moody’s or Fitch. Credit ratings are subject to change. AAA, AA, A and BBB are investment grade ratings; BB, B, CCC, CC, C and D are below-investment grade ratings.
Representative indexes: municipal: Bloomberg Municipal Index; high yield municipal: Bloomberg High Yield Municipal Index; short duration high yield municipal: S&P Short Duration Municipal Yield Index; taxable municipal: Bloomberg Taxable Municipal Bond Index; U.S. aggregate bond: Bloomberg U.S. Aggregate Bond Index; U.S. Treasury: Bloomberg U.S. Treasury Index; U.S. government related: Bloomberg U.S. Government-Related Index; U.S. corporate investment grade: Bloomberg U.S. Corporate Index; U.S. mortgage-backed securities; Bloomberg U.S. Mortgage-Backed Securities Index; U.S. commercial mortgage-backed securities: Bloomberg CMBS ERISA-Eligible Index; U.S. asset-backed securities: Bloomberg Asset-Backed Securities Index; preferred securities: ICE BofA U.S. All Capital Securities Index; high yield 2% issuer capped: Bloomberg High Yield 2% Issuer Capped Index; senior loans: Credit Suisse Leveraged Loan Index; global emerging markets: Bloomberg Emerging Market USD Aggregate Index; global aggregate: Bloomberg Global Aggregate Unhedged Index.
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Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. The value of convertible securities may decline in response to such factors as rising interest rates and fluctuations in the market price of the underlying securities. Senior loans are subject to loan settlement risk due to the lack of established settlement standards or remedies for failure to settle. These investments are subject to credit risk and potentially limited liquidity, as well as interest rate risk, currency risk, prepayment and extension risk, and inflation risk.
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