In this piece, we take key points from our firm's most recent Bond Policy Meeting and share them with our readers. Hopefully, this piece will provide some insight into the economy and fixed income markets and give you a sense of how our team is thinking about recent trends and developments.
Crawford Bond Policy
- From the Fed’s perspective, the base case for the U.S. economy appears to be a soft landing. Current inflation, employment, and GDP growth conditions suggest the economy is in a healthy position. Chair Powell stated the economy is “basically fine” during his press conference, and the median projections in the Summary of Economic Projections (SEP) certainly indicate expectations for a soft landing scenario.
- There is a long way to go in normalizing rate policy, and we acknowledge there are known weaknesses in the economy which deserve continued attention, including deteriorating financial indicators with lower income tier consumers and a tighter relationship between job openings and the unemployed.
- We are optimistic, but remain watchful, and will continue to stay positioned for a soft or hard landing.
- We feel vindicated that the positioning of our strategies has been rewarded on both an absolute and relative return basis since July. We believe we are at the beginning of a monetary cycle which should continue to reward our sector weights and duration management.
- Our Core and Municipal strategies are positioned to:
- Preserve capital with a strong bias to high quality (sector and issuer credit strength).
- Benefit from total return as rates adjust to a more balanced economic environment (yield curve positioning and maturity extension).
- Produce a high level of current portfolio income (bias to higher-yielding spread sectors and above-average coupons).
Treasury Yields as of 9/18/2024
- Nominal U.S. Treasury security yields moved lower across the curve between June and September Bond Policy meetings.
- The 3-Month/10-Year and 2-Year/10-Year Treasury curves steepened 2 and 52 basis points, respectively. The 2-Year/10-Year curve has been positively sloped consistently since September 6th.
- Market-driven inflation expectations (measured by TIPs Breakevens) and real yields declined, reflecting softening economic data and expectations for the Fed to ease rate policy.
- Going into the Fed meeting on September 18th, speculation for the direction and magnitude of rate policy change rested on whether the Fed was more concerned about employment slowing too quickly, or if inflation was falling fast enough.
- The Fed answered with a 50 basis point cut to begin the easing cycle, and the employment picture stole the spotlight from inflation to become the primary focal point in the prepared FOMC statement and Powell press conference.
- Going forward, speculation will persist as to whether the economy will successfully avoid a hard landing (recession). Consequently, economic data will likely receive heightened attention from markets, particularly data related to the labor market.
- Prior to the FOMC meeting, the Bond Market was pricing in a hard landing scenario with Fed Funds expected to drop 225 basis points by mid-2025. The newly released DOT Plot, which illustrates the expectations of each of the 19 Fed Board members, has a total of 250 basis points in easing anticipated for a soft landing scenario by the end of 2026.
- With a soft landing, the expectation would be for a gradual reduction in short-term interest rates as the Fed “normalizes” policy on the way to reaching an equilibrium, or neutral, target rate where policy neither stimulates, nor hinders economic growth.
- If a soft landing proves to be the economic outcome, it is reasonable to expect the yield curve to “bull-steepen,” whereby short-term rates decline more than long-term rates in anticipation of, and in concert with, Fed policy.
Corporate Bond Market
- Demand for high-grade corporates has remained strong despite falling nominal yields and 29% higher year-over-year gross new issue volume totaling $1.22 Trillion.
- Persistent retail inflows to high-grade bond funds and corporate bond new issue metrics demonstrate the continued strength of demand.
- Issuers are paying less relative to outstanding issues (concession).
- There is more in total orders relative to issue size (books).
- Yield spreads to attract orders from initial talk to final pricing are coming down more (compression).
- The fundamental backdrop remains generally supportive with continued balance sheet strength and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margins reaching record highs of ~30%. Decreased CAPEX (Capital Expenditures) has given way to accelerating dividend growth and share buybacks.
- Historically, credit performance after the first Fed cut has been driven by the economic backdrop leading to the cut (soft versus hard landing).
- The graph below illustrates the negative correlation between the 10-Year U.S. Treasury yield and high-grade corporate bond yield spreads. Fear of recession has led to a lower 10-Year Treasury yield and a higher average spread.
- Continued spread compression despite rising interest rates demonstrates the market's confidence in corporate fundamentals and the outlook for the economy.
Municipal Bond Market
- Municipal bond “AAA” scale yields have fallen across the curve since our June Bond Policy meeting.
- The most pronounced movement occurred in shorter maturities, reflecting anticipated cuts in Fed rate policy.
- Municipal bond performance turned positive in July and maintained a relatively steady trend higher through mid-September.
- This positive performance can be attributed to moving in sympathy with Treasury prices, but municipal bonds have lagged Treasuries, challenged by a significant increase in municipal issuance as gross new issue supply reached year-to-date record of $325 Billion. The timing of this supply is consistent with Presidential election years when issuers tend to front-load financing.
- Investor demand has not subsided, however, with retail funds experiencing 28 straight weeks of inflows contributing to a year-to-date total net inflow over $24 Billion.
- The performance lag relative to Treasury securities has created a relative value opportunity as Muni/Treasury yield ratios have widened, the 5+ year part of the yield curve has steepened, and credit spreads have widened across the curve.
- The municipal market should continue to provide attractive entry points through October with elevated issuance levels met with fewer bond maturities.
Summary of Economic Projections and DOT Plot
- Revisions to the economic and policy path projections include:
- Increases to the projected Unemployment Rate in 2024 (+0.40%), 2025 (+0.20%), and 2026 (+0.20%).
- Decreases to projected PCE Inflation in 2024 (-0.30%) and 2025 (-0.20%)
- Decreases to Core PCE inflation in 2024 (-0.20%) and 2025 (-0.10%).
- A 75 basis point decrease to the projected Fed Funds Target Rate in 2024, -75 basis points in 2025, -25 basis points in 2026, and a 12.5 basis point increase in the long run.
- In summary, the Summary of Economic Projections and DOT Plot illustrate the Fed's increased confidence for inflation to reach its 2% target and for the labor market to experience a higher level of unemployment as the economy is brought back into balance.
- Rate policy expectations now total 250 basis points in cuts for the cycle (~2.25 years), as opposed to pre-FOMC meeting futures market projections for 225 basis points in cuts by mid-2025 (~10 months).
Disclosures:
The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Crawford Investment Counsel (“Crawford”) is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Crawford, including our investment strategies, fees, and objectives, can be found in our Form ADV Part 2and/or Form CRS, which is available upon request.
The opinions expressed are those of Crawford. The opinions referenced are as of the date of the commentary and are subject to change, without notice, due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Crawford portfolio. Crawford reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.
Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.
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