Rally On Perceived FOMC Pivot Overdone
August 2022
July proved profitable for fixed income investors with the Bloomberg U.S. Aggregate (Agg) Bond index turning out a 1.8% monthly gain, while credit-sensitive indices fared even better. The longer duration investment-grade Bloomberg Corporate index and the riskier/higher yielding but shorter duration Bloomberg U.S. Corporate High Yield index rallied 2.6% and 5.7%, respectively, on the month. After the yield on the 10-year U.S. Treasury peaked at 3.5% on June 14, the Agg rallied 5.3% through the end of July as market participants ratcheted down expectations for Fed funds rate hikes, going so far as to bake in rate cuts beginning in early 2023. While directionally July’s rally in Treasuries and corporates makes sense given the decline in commodity prices, the magnitude of the move appears extreme, and yields may be poised to reverse higher given that the market is likely misreading the Fed’s intentions.
Market participants took FOMC Chair Jerome Powell’s post-meeting comments in late July as a dovish pivot, and Fed officials were out in full force in early August to push back on that interpretation and talk down the prospect of a near-term policy about-face. With the 2-year U.S. Treasury yield at 3.22% and the 10-year yield at 2.84% as we close out the first week of August, the short end of the yield curve now holds more appeal from a relative value perspective, driven by our view that a near-term Fed pivot is unlikely. As a result, we expect an upward bias to rates on long-dated U.S. Treasuries into September.
The Bloomberg High Yield index fared well on an absolute and relative basis during July as riskier credits rallied alongside stocks with ‘peak inflation’ chatter making the rounds and recession fears receding amid hopes of a Fed pivot. After rallying throughout July, credit spreads on high yield bonds began August at/near levels last seen in early June prior to the FOMC’s meeting at which it announced the first of back-to-back 75-basis point hikes to the fed funds rate. As FOMC members come out in full force over the coming weeks to push back on the market’s expectations of a less aggressive pace of policy normalization, odds of a recession materializing at some point next year should rise and we would expect credit spreads on riskier corporate bonds to move wider. We maintain a neutral allocation to high yield corporates, but investors must pick their spots carefully as valuations again appear ‘fair’ to ‘rich’ given our outlook for economic growth and monetary policy.
Inflation expectations shifted modestly higher in late July as calls for a Fed pivot made the rounds, and as a result, FOMC speakers will continue to make a concerted effort to walk back the prospect of a pivot. Fed funds futures are pricing in better than even odds that the FOMC hikes the fed funds rate by 75-basis points at its September meeting as the July payrolls report gives the Committee cover to remain aggressive. We expect a volatile backdrop for rates to persist with inflation readings closely dissected and market-moving leading up to the September FOMC meeting and would remain nimble and stay diversified within fixed income portfolios as the monetary policy path forward remains highly uncertain.
Source: Bloomberg, Factset
