By Rob Williams, Director of Research
The latest inflation release illustrated the stickiness of inflation, particularly in core components like shelter and medical care. While we believe inflation will continue to trend lower, the pace of that deceleration will be slow, and inflation will remain above trend for some time. Growth data agrees with the notion of a recession, albeit a shallow one with a resilient labor market and service sector.
- CPI Doesn’t Tell the Whole Story. Overall inflation is showing signs of peaking, with energy prices and other commodities dropping over the last several months. While this feeds into overall CPI, core prices are less influenced by this and are showing more of a flatlining pattern. Our base view is that overall inflation will continue to moderate, but core may remain stubborn due to certain lag effects in rents and labor markets.
Overall vs. Core CPI Inflation (YoY)
Source: Sage, Bloomberg
- The Market is Pricing in an Aggressive Fed. The Fed is focused on suppressing long-term inflation expectations by tightening aggressively in the near-term. With the recent inflation figures, the Fed is expected to raise rates by 75 bps during the September FOMC meeting. The futures pricing of the Secured Overnight Financing Rate (SOFR) tells us how the market is pricing in the future federal funds rate. It’s pricing in an additional 175 bps through the end of 2022 to a 4.25% terminal rate for this hiking cycle, which may prove overly aggressive.
SOFR 3M Futures vs. Fed Funds Rate
Source: Sage, Bloomberg
- Looking Past the Near-Term for Fixed Income. Slowly moderating inflation and pockets of strength in the economy will likely keep the Fed hiking rates fairly aggressively into year-end and will continue to pressure rates and fixed income returns in the near-term. Looking a little further out suggests we are approaching a strong period for fixed income, which has typically rebounded after negative returns, had strong returns following Fed cycles, and fared well in recessions.
Conditions for Bond Market Returns (Aggregate Bond Index)
Source: Sage, Bloomberg
*Assumes a -11% return in 2022
- All-In Yield for IG Fixed Income – Highest in Over a Decade. Investment grade corporate bonds are now trading at over a 5% yield, the highest they’ve been in 15 years. Shorter maturity sectors offer a compelling entry point as yield per unit of duration has risen sharply.
Yield (bps) Per Year of Duration Short vs. Intermediate Bonds
Source: Sage, Bloomberg
- MBS Spreads are Near the Widest Levels of the Year. The national average rate on a 30-year mortgage is now over 6%, the highest level since 2007. Nominal MBS spreads, specifically on higher coupons, remain very attractive, especially when compared to corporate credit.
MBS Nominal Spread vs. IG Corporate OAS (%)
Source: Sage, Bloomberg
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