The markets during August: The bond market experienced a modest sell off in August as yields rose on the back of the U.S. Treasury debt rating downgrade by Fitch Ratings, expectations that Treasury issuance will mushroom and concerns that U.S. Federal Reserve Board (Fed) policy may remain higher for longer:
- The benchmark 10-year Treasury yield spiked to 4.34% during the month, hitting its highest level since 2007, before settling back down late in the month.
- Importantly the 10-year Treasury Inflation Protected Security yield rose to 1.98% its highest level since 2009, reflecting the markets concern that bond yields and policy rates could stay higher for longer.
- Meanwhile corporate credit spreads ended the month only slightly wider as continued good economic data and earnings expectations bolstered the potential prospects for forward returns.
- 30-year mortgage rates rose to 7.23%, their highest level since 2001; however, the impact of higher rates is muted by the low mortgage rate many homeowners locked in during the pandemic.
- Based on the most recent jobs report the labor market is cooling, albeit very slowly, while wages continue to grow too quickly. The decline in the July Job Openings and Labor Turnover Survey corroborates this.
- While the most recent CPI report came in as expected, the tailwind of easy baseline comparisons is over, suggesting that inflation’s path back to a pre-pandemic rate gets more difficult from here.
- During his much anticipated Jackson Hole speech, Powell said, “we are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.”
- Interest Rate Risk: We continue to maintain our duration posture at a moderate overweight. The language and tone coming from the Fed indicates continued resolve to tame inflation. Fed rate hiking cycles typically resolve themselves with much lower interest rates (eventually) creating reinvestment risk for short duration bonds and greater capital gain potential for longer duration bonds. Given the recent move higher in yields we believe that longer duration fixed income looks to be a good place to be.
- Credit Risk: We are emphasizing a quality bias in credit positioning. The Fed has been very aggressive in raising rates, and considering the lagged effect of rate hikes, we don’t believe the full economic impact of the tightening cycle has been reached. Once this point is reached we would expect credit risk sensitive sectors to experience more volatility, as the prospects for modestly higher default risk get repriced. In our opinion non-investment grade spreads do not fully compensate investors for the higher default risks that typically come with weakening economic conditions.
- Fed Policy: Despite eleven rate hikes totaling 550 basis points, Fed economists now believe the U.S. can avoid a recession. Given the aggressive tightening campaign this potential outcome may come as somewhat of a surprise. It is important to note that prior policy accommodation may have sowed the seeds of today’s economic resilience. For example, fiscal stimulus before the Fed began hiking rates has likely supported consumption today, while zero interest rate policy allowed businesses and consumers alike to lock in low rates. Furthermore until just recently the Fed was chasing inflation as opposed to proactively being in front of it. As a result these trends have likely delayed, but not thwarted, the impact of tighter policy today. Policy works with variable and undetermined lags. The Fed continues to suggest that it is willing to sacrifice economic growth to bring down inflation.
- Economic Growth & Inflation: Consensus expectations for real U.S. GDP growth in 2023 continue to pick up and now stand at 2.0% according to Bloomberg. Meanwhile GDP growth estimates for 2024, at 0.9%, are below 2023. This pattern of increasing expectations reinforces the notion the economy remains resilient, and the expected slowdown continues to be pushed out. Meanwhile, inflation, as measured by CPI, continues to moderate, with July’s report coming in as expected at 0.2% month-over-month and 3.2% year-over-year. Continued progress is likely to be more challenging and predicated on slowing shelter inflation, which was responsible for 90% of July’s increase in inflation. While signs are pointing to progress on the housing front we will keep our eye on food and energy prices. Finally, generous wage settlements with labor unions and persistently high average hourly earnings, at 4.4% year-over-year in July, may keep inflation from slowing as quickly from here. Negotiations starting between the United Auto Workers, representing 150,000 workers and car manufacturers will be important for setting wage expectations. We expect the lagged effects of monetary policy tightening will continue to build up in the economic data as we enter the fall. A mild recession is our base case, though the timing of that recession continues to shift further out. There is a strong chance that despite potential recessionary conditions the Fed holds rates higher for longer, while continuing to drain their balance sheet. That would be an uncomfortable combination for the markets (namely credit) to bear.
The Yield Curve, as measured by the 10 year and 2 year Treasury yields, inverted at the start of July 2022. At 13 months this is the longest inversion since 1981. Many wonder why we are not seeing more economic weakness by now, especially in labor market conditions. One consideration relates to the lagged effects of monetary policy. Historically, on average, there has been a 13 month lag between the last Fed rate hike and the start of a recession. Another consideration is the fact the fiscal spending from legislation, like the Inflation Reduction Act, the CHIPS Act, and the Employee Retention Tax Credit, continues to spur the economy for now.
Credit Spreads declined slightly during the month. Investment grade bonds saw their spreads (the additional yield over duration equivalent Treasury securities) narrow by 5 basis points to a spread of 117 basis points. Meanwhile high yield spreads narrowed by just 3 basis points ending the month with a spread of 370 basis points. Both investment grade and high yield spreads closed the month below their long-term historical average, despite a continued deterioration in the upgrade to downgrade ratio this year. We expect credit spreads to move higher as economic conditions weaken with a risk of recession.
Should a recession occur, we do expect that it would be relatively mild. Additionally, the high yield index has a much higher quality rating mix than in the past. And there is no maturity wall facing higher yielding bonds; more like a maturity curb. According to Bloomberg just 8% of non-investment grade bonds are coming due before 2024. These factors suggest fewer defaults than would be typical during a recession, but not enough to justify a below average spread.
Absolute Yields for corporate credit rose during the month. The yield for the Bloomberg U.S. Corporate High Yield Index closed the month at 8.4%. Meanwhile the yield for the Bloomberg U.S. Aggregate Bond Index was 5.0% and 5.6% for investment grade corporate bonds. Investment grade yields are still near the highest level seen since 2009. The greater safety of the investment grade indexes and now higher absolute yield does make them look more attractive with a backdrop of slowing economic growth and a Fed that is willing to sacrifice economic growth to tame inflation.
We believe the biggest investment risk in fixed income today has mostly shifted from inflation to economic weakness. In other words from interest rate risk to credit risk. Risk free rates have moved up significantly on the short end of the maturity curve. With higher rates and a falling rate of inflation many bonds now offer positive real rates (adjusted for inflation) - this hasn’t been true for about 3 years. The rising risk is economic weakness and tighter lending conditions are likely to create headwinds for more economically sensitive credit securities. Despite this backdrop the Fed continues to forecast modest positive GDP growth through year-end. With this perspective the Fed risks overstaying a tight policy posture. We believe leveraged loans are more at risk as they will be forced to adjust automatically to the higher rates. From an opportunity standpoint, investment grade yields have become attractive and worth adding to. Though, eventually, as yields for non-investment grade debt begin to discount a recession, we are likely to start advocating for getting more risk exposure.
- Without a doubt the past few years have been extremely challenging for fixed income, but the market has adjusted (painfully) with yields moving higher to better compensate investors for the risk. Challenges remain for sure, but the return potential for high quality fixed income has improved. For example, with the yield on the Bloomberg U.S. Aggregate Bond Index at 5.0% and the index’s duration at 6.2 years, the yield-to-duration ratio (a measure of how much yields would need to jump to extinguish the value of incoming coupon income) sits at 0.8. Theoretically that suggests the yield on the index would need to rise to 6.0% in order for a year’s worth of income to be extinguished. Compare this to where things stood at the start of 2022 when the yield-to-duration ratio was 0.3. The index yield only had to rise 30 basis points to create a loss. While yields could rise modestly from here, the market may have a cushion to absorb that increase in the form of more income. That is why we suggest returns may improve from here and why higher quality fixed income may provide ballast to a portfolio given higher current yields. We believe that investors should consider a more active and flexible strategy that could take advantage of mispriced sectors and rapidly changing market conditions.
- For those investors concerned about either stubbornly high inflation or rising interest rates we suggest considering strategies that have a lower than benchmark duration. That said, should inflation and economic growth slow, as we expect, current long-term interest rates are likely to outperform the very short end of the curve. Additionally, through an active strategy one may be able to access bond categories that sit outside of the Bloomberg U.S. Aggregate benchmark that are investment grade, yet carry more attractive yields.
- For tax aware investors municipal bonds may be a viable option. The Bloomberg Municipal Bond Index outperformed most other bond indexes in 2022. At the end of August a 5 year AAA-rated municipal bond was yielding about 67% of a 5 year Treasury note. A 10 year municipal bond currently yields about 69% of the 10 year Treasury yield. State tax collections have been historically high given pandemic related stimulus measures, though more recently collections have become more mixed with state-by-state variations.
- Looking around the corner. We believe the Fed still holds the key. While they may be near the end of raising rates, the bigger question is for how long they maintain rates at a restrictive level. The Fed’s time frame appears to be much longer than is being discounted by risk assets. We think they may hold rates at current levels until well into 2024. Here are a few considerations.
- Fed Chair Jerome Powell continues to suggest that the Fed is willing to sacrifice economic growth to tame inflation and is inclined to hold rates steady for an extended period to ensure they have fully extinguished inflation before lowering rates. We should take him seriously. Maintaining higher interest rates while draining their balance sheet is likely to trigger a recession. Recessionary conditions are typically beneficial for those positioned in higher quality and longer duration bonds.
- Should we fall into a recession we do believe it will be mild as we have not built up credit excesses that typically aggravate an economic downturn. That combined with a low maturity wall for non-investment grade bonds, should result in a more moderate rise in defaults. We are likely to shift our allocation toward high yield bonds as spreads widen.
- Should inflation fall faster than economic growth, the Fed may be able to pivot to a more easy policy stance before triggering a recession. If a recession is avoided, then default risks diminish and non-investment grade debt likely outperforms. This is not our forecast, but we are watching closely. If evidence builds that we can avoid a recession (all else equal), we are likely to move to a lower quality bias.
Fixed Income Indexes CharacteristicsThe Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
|August 2023||YTD||2022||2021||2020||Duration Years|
|Bloomberg Long Term Treasury||-2.8%||-1.4%||-29.3%||-4.6%||13.6%||16.0|
|Bloomberg U.S. TIPS
|Bloomberg U.S. Aggregate||-0.6%||1.4%||-13.0%||-1.5%||7.5%||6.4|
|Bloomberg U.S. Agg Corporates||-0.8%||2.8%||-15.8%||-1.0%||9.9%||7.2|
|Bloomberg U.S. Agg ABS||0.3%||2.4%||-4.3%||-0.3%||4.5%||2.7|
|Bloomberg U.S. Agg MBS
|Bloomberg U.S. Agg CMBS
|Bloomberg Municipal Bond
|Bloomberg 1-3 year Corporate
|ICE BofA Listed Preferreds
|Bloomberg High Yield
|Morningstar LSTA Leveraged Loan
|Bloomberg Global Agg
|Bloomberg Emerging Markets USD
|August 2023||YTD Change bps||Current Percentile||10 YR Median||10 YR Min||10 YR Max|
|10 year Treasury
|2 year Treasury||4.9%||44||
|10 year TIPS||1.9%||30||100||0.4%||-1.2%||2.0%|
|Bloomberg U.S. Aggregate||5.0%||29||99||2.4%||1.0%||5.2%|
|Bloomberg U.S. Agg Corporate
|Bloomberg U.S. Agg ABS||5.5%||35||99||1.7%||0.4%||5.7%|
|Bloomberg U.S. Agg MBS||5.0%||31||99||2.8%||0.9%||5.4%|
|Bloomberg U.S. Agg CMBS||5.9%||50||100||2.6%||1.4%||6.2%|
Bloomberg Municipal Bond
Bloomberg 1-3 year Corporate
|Bloomberg High Yield
|Morningstar LSTA Leveraged Loan
|Bloomberg Global Agg
|Bloomberg Emerging Markets USD
|Option Adjusted Spreads (bps)|
|YTD Change||Current Percentile||10 YR Median||10 YR Min||10 YR Max|
|Bloomberg U.S. Corporate Agg
|Bloomberg 1-3 year Corporate||74||2||64||65||31||390|
|Bloomberg U.S. Agg ABS||63||-12||76||52||22||325|
|Bloomberg U.S. Agg MBS||53||2||89||31||7||132|
|Bloomberg U.S. Agg CMBS||145||16||91||95||62||275|
|Bloomberg High Yield||370||-98||36||396||262||1100|
|Bloomberg Emerging Markets USD||320||-125||52||317||211||720|
For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
2020 – Pandemic. Fed in massive stimulus mode. Interest rates dropped precipitously. Credit rallied after Fed started buying junk bonds and fiscal stimulus measures appeared to be more than enough to offset economic downturn.
2021 – Pandemic continued in waves. Fed held rates near zero and continued to grow its balance sheet at a moderate pace. Long duration bonds sold off while Treasury Inflation Protected Securities rallied on inflation concerns. Exclusive of duration credit exposed securities generally earned their yield.
2022 – The Fed embarked on one of its most aggressive tightening paths seen in decades as the inflation rate surged well above their goal. Interest rates rose across all maturities leading to one of the worst years for fixed income returns.
The Touchstone Asset Allocation Committee (TAAC) consisting of Crit Thomas, CFA, CAIA – Global Market Strategist, Erik M. Aarts, CIMA - Vice President and Senior Fixed Income Strategist, and Brian Cheyne, CFA, CIMA - Senior Investment Strategy Specialist, develops in-depth asset allocation guidance using established and evolving methodologies, inputs and analysis and communicates its methods, findings and guidance to stakeholders. TAAC uses different approaches in its development of Strategic Allocation and Tactical Allocation that are designed to add value for financial professionals and their clients. TAAC meets regularly to assess market conditions and conducts deep dive analyses on specific asset classes which are delivered via the Asset Allocation Summary document. Please contact your Touchstone representative or call 800-638-8194 for more information.
A Word About Risk
Investing in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. Mortgage-backed securities and asset-backed securities are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. Foreign securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. Emerging markets securities which are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
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