Perspectives

Midway through the third quarter, the soft-landing scenario was briefly upended by an unexpected weakening in the labor market that sparked fears around growth and a potential policy mistake. A sharp rise in the unemployment rate triggered a popular recession indicator and sent markets into a state of heightened volatility. While the employment side of the Fed’s dual mandate was starting to deteriorate, benign readings in inflation data furthered confidence the 2% target was in sight. With inflation risks ebbing, the key determinant to upcoming monetary policy decisions shifted squarely to employment. Fed Chair Powell wasted no time in indicating that further cooling in labor-market conditions were not welcome and that a rate cut was forthcoming. Citing greater confidence that the risks to achieving its employment and inflation goals were roughly in balance, the Fed cut rates by 50 basis points at the September FOMC meeting and indicated another 50 basis points of cuts by yearend. The Committee also signaled an accommodative policy path, projecting a longer-term fed funds rate of 2.75-3.0%.

Bond Market Performance

The Bloomberg Aggregate Bond Index delivered a strong return of 5.2% for the third quarter, with all sectors of the taxable bond market delivering positive total and excess returns. Overtly dovish messaging, combined with weakening employment data, drove interest rates significantly lower. The front end of the yield curve led the rally, with 2-year and 10-year Treasury yields sliding 111 and 62 basis points, respectively. This bullish steepening pushed the slope of the 2s-to-10s yield curve into positive territory for the first time in two years. If the economy manages a soft landing, the recession foretold by the yield curve will go down as the biggest false signal in history.

Corporate Bond Markets

The corporate bond market continued to herald a benign economic outlook, indicating little more than a 10% chance of a recession, in contrast to the 30% odds assigned by economists. Aside from a brief bout of risk-off sentiment in early August, spreads traded in a narrow range and within a few basis points of their GFC tights. Within the high yield sector, lower-quality idiosyncratic stories in CCC-rated securities drove spreads 166 basis points tighter, handily outperforming the higher-quality BB-sector, which saw modest spread widening. The corporate sector continues to benefit from a strong fundamental backdrop supported by solid balance sheets, resilient earnings, and low-default rates. Supply-demand dynamics remain favorable as robust issuance is met with investors’ insatiable appetite for appealing all-in-yields.

Within the securitized space, Agency MBS performed well as 30-year nominal spreads tightened, helping drive positive excess returns relative to corporates. Spreads remain attractive from a historical standpoint and offer appealing risk-adjusted returns relative to many lower-quality areas of the corporate market. Specified pool valuations stand to benefit from the concern around higher prepayment activity as investors seek call protection. Asset-backed securities widened modestly, but continue to offer an attractive high-quality source of income in the front end of the yield curve.

Economic Outlook

While the risks to the economy have undoubtedly risen, a soft- landing scenario remains our base case. We believe that after an extended period of restrictive monetary policy the economy is slowly moderating, not collapsing. Strong consumer spending, subdued inflation, and a recalibration of Fed policy are all supportive of modest growth ahead.

Absent a significant deterioration in the economic outlook, we expect to see a protracted period of range-bound rates. The futures market has already fully discounted the Fed’s projected easing policy path to be realized by early 2026, making it difficult for front- end maturities to rally meaningfully from here. On the other hand, with the Fed recalibrating before declaring total victory on inflation, and with fiscal policy still aggressively stimulative, the yield curve could see longer rates sell off. While rates have slipped off recent peaks, they remain attractive relative to post-GFC history, and any significant weakness is likely to be capped by investors seeking compelling absolute yields.

A soft-landing scenario and the return of the so-called “Fed put” is a supportive setup for risk assets to be emphasized for the positive carry. That said, tighter valuations, a slowing economy and heightened concerns around the downside risks, warrants an up-in-quality bias and defensive positioning within the spread sectors.

Read GW&K’s full Quarterly Investment Review for the third quarter here.

With contributions from members of our Taxable Bond Team