After rising in response to better than expected economic data through the first 4 months of the year, bond yields reversed course and fell sharply in May due to weak employment numbers combined with Powell ruling out rate hikes this year during his May FOMC press conference.
Inflation continues its slow descent, as indicated by one of the most important measures of inflation – wages. So, while the labor market has been strong, wages are continuing to decline steadily. Despite the pace of inflation decline being much slower than expected, the Fed remains determined to be on the side of cutting rates rather than raising them this year.
Last month saw economic data surprise to the downside versus heightened expectations. The Economic Surprise Index, which tracks economic data releases relative to consensus expectations, moved lower and is negative for the first time this year. In April and early May, expectations for strong growth and strong inflation were higher than reality, and data is starting to show some slowing in the economy.
Over the last eight months, fixed income and rates have seemingly behaved as if on a pendulum. Interest rates swung far lower in the fourth quarter, represented by the light blue bars, as economic data surprised to the downside and the Fed indicated the onset of rate cuts in 2024. A stronger economy and more robust inflation to start the year caused rates to swing sharply to the upside (dark blue bars). Bond yields reversed again after the FOMC’s May 1st meeting, where Fed Chair Jerome Powell largely ruled out rate hikes for this year. Ten-year Treasury yields have fallen by 22 basis points since then (grey bars).
Coming into 2024, the market was pricing in nearly seven cuts for the year; however, Fed expectations retraced to only one cut fully priced into 2024 after the Fed’s May 1st meeting. We believe the distribution of outcomes for interest rates remains skewed to the downside as there are still an abundance of data releases to come this year, coupled with a Fed that will be more likely to react to a downside surprise rather than stronger economic data.
An abundance of US liquidity, which supplies money and credit to markets and the real economy, is keeping spreads tight and bolstering demand for fixed income. Since 2022, liquidity conditions have improved primarily due to a high level of fiscal spending and, most recently, the Fed altered its balance sheet policy to reinvest a higher level of treasury maturities, which on balance will result in more funds and liquidity available to the financial system. Consequently, we’ve seen a grind lower in investment grade corporate spreads, which are now at near-cycle lows. Since credit spreads are offering very low risk premium, we remain cautious and are focused on security selection. We are overweight mortgage-backed securities, which remains a favored quality tilt with attractive valuations vs. credit.
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