Top 5 Fixed Income Market Insights for 2023: Mid-Year Update

2. Bank on the banks

Rationale

The U.S. banking system has significantly bolstered its financial wherewithal since the Global Financial Crisis (“GFC”). Over a trillion dollars of capital has collectively been added to the banking system’s equity base since 2009, while accounting changes that took effect in 2020 have pushed banks to hold loan loss reserves to cover expected lifetime losses rather than just one year of losses.

Portfolio in Action

While we reduced our overall exposure to the banking sector through a reduction in regionals and certain hybrid capital positions, we remain confident in the largest money center banks. Concerns around commercial real estate, among other things, lead us to believe that stress in regional banking still exists. Therefore, our exposure is still biased towards G-SIBs (Globally Systematically Important Banks) which remain very well capitalized while maintaining strong liquidity profiles.

Mid-Year Status: Mixed but Recalibrate

The largest money center banks continue to be well capitalized but higher interest rates prompted concerns that growing unrealized asset losses on bank balance sheets could erode a bank's capital levels. This is particularly acute for smaller regional banks who have struggled to meet deposit outflows without raising liquidity from asset sales. Many of these regional banks still face further pressure from a weakening commercial real estate market that would directly impact their loan books. Meanwhile, larger money center banks have been net beneficiaries of deposits flows and we expect them to continue to reap the benefits from a much broader funding base and diversified business models.

3. Peak volatility behind us

Rationale

Periods of elevated bond market volatility typically create pockets of dislocation across certain segments of the market. One sector that has benefited from the recent rate volatility is Agency mortgage-backed securities. In the case of mortgage securities, we believed that a reduction in demand from the Federal Reserve as part of their quantitative tightening (“QT”) program would provide an attractive entry point.

Portfolio in Action

As interest rates have risen and mortgage spreads widened, we have been buyers of current coupon mortgages offering higher yields and good liquidity. Moreover, these securities will benefit from a meaningful decline in mortgage refinancing, slower new home sales and overall reduced housing turnover that has eased the supply of mortgage origination.

Mid-Year Status: Mixed

Mortgages suffered in 2022 due to multiple factors: 1) elevated rate volatility, 2) the disappearance of two large buyers, banks and the Federal Reserve, and 3) aggressive tightening of monetary policy that created an inversion of the U.S. Treasury yield curve. Mortgages have cheapened and technical pressure due to the persistence of higher volatility levels have kept them cheap.

4. Disinflationary progress

Rationale

The full effects of Fed tightening, which always operate with long and variable lags, is now beginning to impact the broader economy. This suggests weaker aggregate demand in the second half of the year. In addition, labor supply and demand are moving into better balance, which should further reduce wage pressures going forward. Excess housing savings also continues to decline and point to a less resilient consumer going forward. And finally, last year’s moderation in rent increases is beginning to show through to reduced housing inflation as reported by the Bureau of Labor Statistics and the Bureau of Economic Analysis.

Portfolio in Action

We continue to maintain a longer duration bias in portfolios as we believe inflation will continue to drift lower as the Fed maintains restrictive policy rates. We believe the Fed will ultimately need to lower rates on the back of slower growth and falling inflation.

Mid-Year Status: On Target

While inflation has proven to be stickier than anticipated, developments still point to lower inflation by year-end. However, a tight labor market and resilient economy have made the Fed’s job more difficult, and will remain so particularly if inflation expectations drift higher. However, we believe the Fed will be successful in reducing inflation and longer-term policy rates will re-normalize.

5. Quantitative tightening (QT) an unknown risk

Rationale

As the Federal Reserve seeks to reduce the size of its balance sheet in a process known as quantitative tightening (“QT”), a lack of liquidity will likely continue to weigh on the market’s ability to function normally.

Portfolio in Action

Improved overall liquidity profile of portfolios by increasing quality and rotating into U.S. Treasuries and Agency MBS. We have also reduced exposure to lower rated debt, including high yield and emerging market debt, where applicable. Lastly, we have emphasized on-the-run issues relative to off-the-run.

Mid-Year Status: On Target

We continue to monitor whether quantitative tightening will impact bond market liquidity and overall market functioning. So far this year, liquidity metrics have remained relatively stable. Still, the coming wave of bill issuance following the debt ceiling resolution potentially presents a new risk to a healthy functioning market. To the extent increased bill issuance leads to a fall in bank reserves, banks will be pressured to reduce their securities holdings in order to maintain liquidity.