Fixed income perspective – from the Investment Advisory Group

Peak in U.S. Treasury yields likely in rear view mirror

• Last week, we highlighted that yields across much of the U.S. Treasury yield curve offered a compelling entry point. Fed hawkishness and hot inflation had lifted short and intermediate yields close to cycle-highs. Concerns around the banking sector have since ignited a powerful flight into U.S. Treasuries, driving yields sharply lower (see chart).
• Over the past year, rising bond yields (i.e., declining values) and Fed rate hikes have created a challenging dynamic for some banks to manage balance sheets and maintain typical deposit levels. The recent difficulties in the banking system are likely to encourage banks to tighten lending standards, thus creating a drag on U.S. growth in the months ahead.
• The Fed faces a very difficult decision at next week’s Federal Open Market Committee meeting. It must decide whether to prioritize financial stability or its fight against inflation. Whether or not the Fed raises rates by 0.25% or not, we believe the Fed’s overall rate hike cycle is effectively over. However, inflation will need to continue carving a clear path lower before the Fed will begin cutting rates at the swift pace the market now expects.
• The combination of a Fed pause in the months ahead, signs of cooling (albeit slowly) inflation, and a slower growth outlook suggest this cycle’s peak in U.S. Treasury yields is most likely behind us. We are lowering the top end of our 10-year trading range to 4% from 4.25% and would view a move above 3.75% as an opportunity to extend duration for portfolios that remain short of their benchmark.
• We maintain our long-of-benchmark duration bias for fixed income portfolios. Longer duration and higher quality fixed income have tended to outperform shorter-dated debt and lower-rated bonds as the economy slows or enters a recession. They also tend to enhance portfolio stability during periods of stock market volatility.
• Over the past 7 trading sessions, the S&P 500 index has declined roughly 4%. Meanwhile, core fixed income* has advanced roughly 3%. As market sentiment deteriorated, investment grade fixed income cushioned overall performance in balanced portfolios and re-established a healthier inverse correlation between stocks and high-quality bonds. After last year’s sharp yield rise, fixed income is far better positioned to deliver its typical diversification benefits. 
• We reiterate our high-quality bias in fixed income over the very near term, emphasizing areas such as U.S. government and investment grade municipal bonds.

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