“Philosophers have argued for centuries about how many angels can dance on the head of a pin, but materialists have known all along that it depends on whether they are jitterbugging or dancing cheek to cheek.” ― Tom Robbins
Bond market technicals have done a complete about face since the beginning of 2023. Not only are high-quality corporate bond spreads rallying back to levels not seen since Q1 of 2022, but tertiary securitized sectors, including in asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), have posted strong excess returns as well. With only a modest improvement in the macro-economic data, we feel two key “gut-check” questions are 1) what has really changed and 2) are the changes here to stay?
1. What Has Really Changed?
Bond market psychology can be brittle. One day there aren’t enough bonds to go around, and the next, buyers run for the hills. This stokes daily volatility as issuers rush to market, market tens-of-billions in long-term debt, build massively over-subscribed order books, and then pray that bad economic data or hawkish Fed officials don’t slam the market shut before they price into the market. We’ve witnessed this “rush-to-market-before-it’s-too-late” approach repeatedly over the past several months, and yet we seem to suffer amnesia when the pricing becomes exceptionally frothy.
The latest bout of frenzied buying has been fueled by the perception that the scariest economic outcomes – runaway inflation and/or a severe recession – have been vanquished. The unbounded economic “paradigm shifting” risk that seemed so frothy to bond investors in 2022 has been replaced by a more sanguine type of uncertainty consistent with “normal” economic cycles. The MOVE index recently dropped below 100bps for the first time since last June, and the Bloomberg Corporate Index OAS traded inside +120bps for the first time since April 2022. Neither implies economic goldilocks, but the sharpness of this rally belies any possibility of the inflation’s “raging inferno,” as Neel Kashkari put it last August, from returning in 2023. Once again, January is the month when “hope springs eternal” in the bond market.
2. Are the Changes Here to Stay?
Has the Fed truly tightened just the right amount? Fed officials have repeatedly stated that they are slowing their pace of hikes to allow for the data to catch up. The economy has a long, multi-faceted transmission mechanism with many asynchronous, but integral components. Most of the inflation gains have come from improvements in supply chains and a relaxation in demand for energy, automobiles, and travel. This is expected — the money supply and fiscal stimulus spigots have been arrested. But trends in wages and core services CPI remain concerns, whilst corporate earnings, residential home sales, and C&I lending are flashing contraction signals. All this could be evidence of post pandemic structural dislocations in an economy facing a prolonged period of stagflation. If that is the case, the market’s expectation that the Fed will cut rates anytime soon is far-fetched and overpriced.
Last Saturday, the temperature in Boston hit -10 degrees for the first time since 1957. Two days later, the daily low was up to +24 degrees. It felt downright balmy in comparison. But it’s not spring yet. Punxsutawney Phil saw his shadow and we still have at least 6 more weeks of freezing weather in the northeast. The forecast for the Fed and the economy should be treated similarly, as we may still have a long way to go in this season of volatility.
Sources: Bloomberg as of 2/7/23. Neel Kashkari quote sourced from: https://www.financialexpress.com/investing-abroad/featured-stories/jackson-hole-latest-inflation-likely-to-be-high-for-a-while-imfs-gita-gopinath/2646439/. This is not a recommendation to purchase or sell any specific securities. Actual results may differ. Yields are represented as of the above date(s) and are subject to change. The views contained in this report are those of Income Research & Management (“IR+M”) and are based on information obtained by IR+M from sources that are believed to be reliable but IR+M makes no guarantee as to the accuracy or completeness of the underlying third-party data used to form IR+M’s views and opinions. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. Investing in securities involves risk of loss that clients should be prepared to bear. More specifically, investing in the bond market is subject to certain risks including but not limited to market, interest rate, credit, call or prepayment, extension, issuer, and inflation risk. It should not be assumed that the yields or any other data presented exist today or will in the future. It should not be assumed that recommendations made will be profitable in the future. Actual results may vary. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management. “Bloomberg®” and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by IR+M. Bloomberg is not affiliated with IR+M, and Bloomberg does not approve, endorse, review, or recommend the products described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any IR+M product.