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Written by: Tracy Nolte | Advisor Asset Management
We are less than 10 days away from the next Federal Open Market Committee (FOMC) meeting where, again, markets are optimistic that the FOMC will raise rates another 25bps (basis points) and pause. At the very least perhaps, the FOMC might not raise rates but rather communicate what Cliff Corso, CIO for Advisors Asset Management, has described as a “hawkish pause.”
Prior to the most recent FOMC meeting on May 3, a surge of unfounded optimism abounded. This widely broadcast market view expected the committee to take a breath at the May meeting and perhaps announce victory, or at least a temporary stalemate, over the forces of inflation which had vexed the U.S. economy for over a year. The increasingly optimistic outlook can be seen in the Treasury markets as — in the three days leading up to the May 3 FOMC announcement — the 2s10s (2-year Treasury vs 10-year Treasury) curve inversion reduced by 17bps, from -58bps to -41bps.
As a result, the hawkish stance of the May 3 FOMC statement and Chair Powell’s post-announcement presser appeared to catch the equity and fixed income markets flatfooted. On May 4, one day following the announcement, the S&P 500 Index closed down by 0.76% and stood at a -2.56% for the month. Credit markets followed suit. The ICE BAML Broad High Yield Index widened by 16bps on May 4 alone and stood 40bps wider for the month. In a trade that reflected both higher short-term rate expectations and expectations for softening economic activity, the Treasury curve began an inexorable decline into further inversion. Short-term rates adjusted to higher FOMC expectations by adding 34bps to 1 million Treasuries while tenors in the belly of the curve fell by 12–20bps.
Following the May 3 FOMC meeting, expectations that inflationary pressures had subsided enough to address FOMC expectations kept running into reality. Optimism that improvements were occurring quickly enough to warrant a pause, much less a near-term rate cut. During May, a number of top tier economic indicators began to paint the picture that the FOMC would likely continue to be more hawkish than was assumed a few short weeks prior.
Average hourly earnings grew at 4.40% annual rate during April:
- ISM Price Paid survey climbed to 53 in April from 49 in March.
- Preliminary Unit Labor Costs for the 1st quarter of (Q1) 2023 were 4.20%, up from -2.20% in Q4 2022.
- Consumer Price Index (CPI) headline and Core CPI inflation moderated a mere 0.10% from the prior month.
- Nondefense ExAir Durable Goods orders grew at 1.40% in April versus -0.10% in March.
By the end of May, continued economic strength had driven the 2s10s yield curve back to a -76bps, a level last seen in March of this year. Markets were forced to reconsider the possibility that the FOMC would remain restrictive for longer, while also acknowledging the historic reality that FOMC restrictive policy measures have consistently led to recessions.
Our capital markets expectations, supported in part by some of the economic signals mentioned above, provide the framework from which our credit and duration exposures are developed and implemented. These expectations serve as the foundation for our investing playbook. As a result, our playbook for late-expansion fixed income investing continues to position assets for an economic slowdown and in doing so focuses on:
Incrementally higher credit quality: Fixed income investors must be prepared for spreads to widen. We believe they must also make a concerted effort to account for higher default rates and wider credit spreads which occur during economic slowdowns.
Broadly defensive duration: We continue to avoid unnecessarily longer-duration exposures because we do not believe there has been a durable steepening of the yield curve. As witnessed in May, the opposite has occurred.
As previously mentioned, it is possible that in their attempt to temper inflation the FOMC will engineer a soft-landing instead of a recession; however, history shows that this is usually not the case. We continue to skate to where we believe the puck will be and for fixed income investing that means discovering value through appropriate credit exposure, understanding what credit risk can do to a portfolio during an economic slowdown, and maintaining careful duration distribution. Following this playbook has the potential to allow fixed income portfolios to acknowledge the lessons from history and, we believe, prepares these portfolios for better outcomes.
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