INSIGHTS

On November 07, 2022

AAM Viewpoints — A Look Back at Q3 Fixed Income Markets and Performance

It was a relentless march higher for interest rates during the 3^rd quarter (Q3) as ongoing inflationary pressures pushed the FOMC (Federal Open Market Committee) to flex their inflation-fighting credentials. Investors continued to experience the sting of volatility and the spector which hung over markets in Q2 continued unabated. Policy stance clarity became critical as the Fed marched out even the most ardent of prior doves to declare that inflation was their number one priority. Within the prior 12 months, the FOMC moved from a focus on transitory inflation through a period expressing hope of a soft landing to something akin to grabbing the rates market by the shirt collar and making them sit up straight in their chair.

Source: U.S. Federal Reserve

During Q3 there was no shortage of inflation-centric commentary from Fed officials and little of it pulled any punches. The Fed’s forceful focus on inflation expections worked to not only quell dubious suggestions that a pivot was at the doorstep, but to also make abundantly clear that neither the labor market nor a possible recession would stop the Fed from their price-stability mandate. As if to emphasize that the FOMC continued to have their work cut out for them, both PPI (Producer Price Index) and CPI (Consumer Price Index) inflation releases for September surprised to the high side. While the hallmark of Q2 was the difficulty the FOMC had convincing markets they were serious, the hallmark of Q3 was that markets became convinced that they weren’t kidding.

Source: U.S. Federal Reserve

Fixed income markets grasped for an estimate of the terminal funds rate during Q3 and through the “dot plot,” meeting minutes, and official speeches as a range of 4.00–4.50% emerged. The result was that rates moved inexorably higher across the breadth of both the real rate and nominal rate curves to more appropriately discount the decreasing wedge between inflation and expected Fed policy. Implied breakevens — the difference between nominal rates and real rates — began to mercifully decline and as a result, ones-year inflation breakevens fell from 4.12% at the start of the quarter to 1.61% when the quarter closed out.

Our Chief Investment Officer, Cliff Corso, often says “There is no better cure for high prices than high prices.” While pithy, it remains nonetheless a perfect summary of the demand-driven components of inflation, how they are being clearly targeted by Fed policy, and our expectations for the coming 12 months. The FOMC will continue to make capital expensive and the more expensive capital become, the less inflationary pressure there is from demand. While the Fed has only been raising rates since March, housing demand has already begun to rollover and reminds us of the saying, “As goes housing, so goes the consumer.” Shelter costs from housing account for nearly 30% of CPI and while the weighting in PCE (Personal Consumption Expenditure) is only about 15%, it is clear that the rollover in housing portends a broader softening of demand-side pressures. Subsequently we expect that as demand rolls over, one piece of the inflationary issue will be addressed. However, supply-side inflation remains the other component to be wary of.

The result of the FOMC’s control over the cost of capital leads to a subsequent decline in economic output within the next 8–12 months.

Longer-term rates drifted higher during the quarter for a variety of reasons, but one critical rate component was connected to the Fed’s balance sheet activity. Quantative easing had been a tool by which the FOMC was able to maintain artificially low rates in the post-2008 world, but as the Powell-led Fed moved to reduce their buying activity in the rates market, it reduced the downward pressure on rates and allowed rates to rise in a manner similar to a balloon being held underwater.

Source: U.S. Federal Reserve | Past performance is not indicative of future results.

With the removal of the “Fed Put,” other market participants who had been wisely following the Fed, began to migrate into their preferred maturity/duration habitat and also into other assets. Demand for debt declined and rates in these portions of the curve naturally gravitated higher. In Q3, for the first time since 2020, the entire breadth of the real rates curve turned positive. This rise in rates coupled with short-term rate adjustments jawboned into the market by the FOMC drove 2s10s (spread between 2-year U.S. Treasury rates and 10-year U.S. Treasury rates) and 5s30s curves deeper into inversion. As detailed earlier, there are very specific and important reasons that the yield curve remains a critical forecaster of future activity, most notable at present being that curve inversions are typically hallmarks of later recessions.

While the concerns earlier in the year were that the FOMC has been on the back foot regarding inflation, they have attempted to firmly reassert their inflation-fighting credentials in the last two quarters. However, as they do, critical components of rising inflationary pressures remain outside the central bank’s immediate control. These ongoing pressures inform our thesis that higher inflation may not be completely addressed by the FOMC’s restrictive policy actions and the resultant demand-side declines. Remember, the Fed can neither plant crops nor drill for oil. Supply-side pricing pressures resulting from wounded supply chains take time to heal and when combined with the “un-globalization” move afoot in many supply chains, pricing pressures may continue to keep inflationary forces higher in components which reside outside of the FOMC’s purview.

Economic projections from the September FOMC confab indicate that Fed board members are expecting unemployment to rise to 4.40% in 2023 from the historic 3.50% low. Fed Funds is projected to be lifted to a median 4.60% along the way. The combination of these factors is enough, the FOMC projects, to drive PCE inflation down to 2.80% next year.

It has long been our position at AAM to not fight the Fed, especially when they tilt to being restrictive. Restrictive monetary policy is more often associated with recessions than it is with soft landings and as a consequence we believe that the risk to the economy is skewed more to the downside than it is to the upside. Asset management is about positioning assets based on where the economy is headed. Our strategy focus during the coming quarter will be making the necessary strategy changes to do so and continue “skating to where the puck is headed.”

We have been incrementally adjusting our asset allocations to be more defensive throughout the year and the change in market forward sentiment confirmed our thesis. One can smell smoke, and to the portfolio management team at AAM, all of the items below corroborate the growing body of evidence suggesting a slowdown should be planned for and our defensive tilt continues to appear correct.

• Restrictive monetary policy and ongoing FOMC jawboning
• Inverted yield curves
• Elevated market volatilty
• Widening credit spreads

Source:  ICE BofA ML Market Indices | Past performance is not indicative of future results.

Through the end of Q3, the ICE Bank of America Merrill Lynch (BAML) Broad Corporate Index had it’s worst ever start to a year since 1977 at -18.33% while the ICE BAML Broad High Yield Index has had its second worst yearly start since 1987 returning -14.62%. However, when it comes to fixed income returns, credit exposure has provided some cover to investors as U.S. Treasuries have suffered their worst ever year-to-date return with the ICE BAML Broad Treasury Index down 13.37%. Returns across the board are negative but the bulk of these negative returns appear to be the result of an aversion to duration and not to credit…yet.

Source:  ICE BofA ML Market Indices | Past performance is not indicative of future results.

Credit continued to have a “wind in its sails” moment. As you can see from the charts, the yield appeal combined with the shorter duration exposure of high yield is a compelling story. These factors have made credit exposure relatively attractive even in these unattractive markets. Spreads on lower quality credit continued to be contained throughout Q3 and have not yet materially widened in a manner one would expect considering the outlook for 2023.

Source:  ICE BofA ML Market Indices | Past performance is not indicative of future results.

Uncertainty has begun to drive some credit risk wider as CCC and lower-rated credits widened an additional 87bps (basis points) during Q3. We believe that the angle of attack for the FOMC will eventually run spreads wider through a broader selection of lower-quality credit and that spreads are more inclined to widen further from these levels than they are to tighten. The reasoning to maintain credit exposure in the face of a material economic slowdown will become less convincing as things begin breaking.

As a result, we have modified our capital market expectations for the next 12–18 months and this subsequently modifies our approach to managing taxable fixed income strategies. Experience has shown that tactical adjustments to credit and duration exposure have the potential to mitigate the effects of widening credit spreads, increased volatility, and credit default risks. Also during these periods, we may incrementally increase our targeted duration to attempt to mitigate our exposure to short-term rate volatility. Tactical duration exposure may also proactively position the strategies to monetize the decline in interest rates which eventually occurs when the markets anticipate the FOMC shifting to less restrictive policy. Consistent with our approach to fixed income investing, carefully curated credit exposure combined with a well-reasoned approach to interest rate risk are nuanced methods aimed at tempering the risks present in the economy. These factors continue to highlight the importance of active management in fixed income assets across the breadth of the business cycle.

CRN: 2022-1103-10445 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.