Bonds Commentary
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Inflation Vs. Recession Tug-Of-War Ongoing

July 2022

Interest rates have been riding a volatility rollercoaster in 2022, a byproduct of monetary policy and economic uncertainty, and June was no exception. After eclipsing 3.5% mid-month, the 10-year U.S. Treasury yield moved lower in dramatic fashion to end the month below 3% as fears of a U.S. recession generated a bid for safe-haven Treasuries. Notably, the 10-year Treasury yield traded in a 70-basis point range between 2.85% on the low side and 3.55% on the high side during June, but the yield on the 10-year Treasury closed just 13 basis points higher at 2.98% as market participants pivoted from fearing inflation mid-month to pricing in a U.S. recession to close out the month. Global central banks are adjusting their messaging and the pace of policy normalization on the fly as the economic backdrop is evolving, and as market participants try to reposition to keep up with expected policy shifts large intra-day moves in rates are likely to remain a constant throughout the summer.

The Eurozone Consumer Price Index (CPI) for June rose 8.6% year-over-year after an 8.1% jump in May, taking the ‘peak inflation’ narrative off the table for Europe. The European Central Bank (ECB) has signaled its intention to raise key interest rates by 25 basis points at its July meeting, initially sparking selling in Euro Area sovereign bonds, but yields across the continent fell into month-end as recession fears dominated. As the ECB telegraphed plans to begin raising rates, it downgraded its forecast for growth in the Euro Area and revised its forecast for inflation upward. The revisions were not a surprise directionally, but the magnitude was as the ECB’s inflation projection for 2022 jumped from 5.1% in March to 6.8% in June, while its economic growth forecast was revised lower to 2.8% from 3.7% in March. Peripheral European countries are least capable of weathering slowing economic growth and rising inflation, but higher quality sovereign issuers are also likely to face headwinds as European Union (EU) countries are often viewed as guilty by association. Stronger EU member nations have traditionally been called upon to support or backstop the debt of weaker EU members to stabilize markets, and this possibility was discussed by the ECB in June as yields rose and credit spreads widened on peripheral sovereign bonds. This time around, Europe’s ‘core’ is already balking at stepping in as a backstop, which could prove disastrous for Euro Area bonds broadly.

FOMC members talked tough on inflation in June, despite market participants ratcheting the odds of a U.S. recession higher into month-end amid signs of a weakening economy. Yields on long-dated U.S. Treasuries were forced lower as a result. To take advantage of higher yields and to position for the possibility that the FOMC could tighten the U.S. economy into a recession, we modestly increased our portfolio duration in May to match that of the Bloomberg US Aggregate Bond index. Coinciding with our move to extend duration, we reduced exposure to mortgage-backed securities (MBS) and deployed capital into a core-plus strategy with a broader opportunity set. With yields on investment-grade and high yield corporate bonds higher at month-end, investors are better compensated for taking credit risk. However, slowing U.S. and global economic growth could spur additional spread widening and investors, us included, will likely require much higher yields before allocating additional capital to the space.

Source: Bloomberg, Factset

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