Beyond Short-Term Fixed Income Volatility

Fixed income outlook in 5 charts
By Rob Williams, Director of Research

The main factor for the markets is now the trajectory of US inflation. The Fed remains hyper-focused on reducing inflation and has been reluctant to take into account increased market volatility, deteriorating conditions or strains on the global economy caused by the rising US dollar. Until inflation starts to show signs of slowing (2-3 months of consecutive negative surprises) or there are serious financial stability issues, the Fed will continue to tighten financial conditions.

1) The Fed will continue its hike. The most recent Consumer Price Index (CPI) print surprised on the upside and was an indicator that prices and inflation are still too high for the Fed’s liking. As labor, manufacturing and rental markets improve, gasoline prices have started to climb.

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Consumer price index
Source: Sage, Bloomberg

2) Markets price a higher terminal fed funds rate. Real interest rates continue to rise and have passed their peak after the Great Financial Crisis. SOFR futures are an indicator of market expectations regarding Fed policy. SOFR futures forecast a maximum policy rate in the second quarter of next year of 4.75% to 5%. The good news is that the market is largely pricing in this terminal rate.

Guaranteed Overnight Funding Rate (SOFR) Futures Curve
Source: Sage, Bloomberg

Beyond Short-Term Fixed Income Volatility

3) Look beyond the short term for fixed income securities. Slowly moderating inflation and pockets of strength in the economy will likely keep the Fed on rate hikes through the end of the year. As a result, fixed income rates and yields will continue to come under pressure in the near term. Beyond that, historically we are approaching a strong period for fixed income. Post-Fed cycles, negative bond market years and recessions have all seen strong fixed income returns.

Bond market returns over the next 12 months
Source: Sage, Bloomberg

*Average returns following a negative bond market have averaged 6% (assuming -10% in 2022) *Recessions are typically associated with positive bond market returns (+6.8% on average for the four years) *Bond markets generally recover after the Fed Cycle, anticipating declines (+11.8% over the 12 months following the last four cycles)

4) Spreads on mortgage-backed securities are on par with BBB companies. The national average rate on a 30-year mortgage is now over 7%, the highest in 20 years. MBS spreads have widened to a level not seen since the depths of the Great Financial Crisis and offer an attractive entry point.

Nominal spread MBS vs. BBB Corporate OAS
Source: Sage, Bloomberg

5) Municipal bonds are a defensive game. Municipal cash outflows hit a record $100 billion year-to-date, leading to significant volatility and negative returns. Municipal yields have been revised higher along with Treasuries and provide a very attractive entry point. Also keep in mind that munis’ worst declines in the last 20 years were short-lived and painful, with an average decline of 8%; however, these periods were always followed by strong rebounds of nearly 9%.

Municipal cutbacks and rebounds over the past 20 years
Source: Sage, Bloomberg

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