Treasury yields rally strongly on softer economic data

Weekly fixed income update highlights

• Total returns were positive across fixed income asset classes, including Treasuries, investment grade corporates, MBS and emerging markets.
• High yield corporates and senior loans had negative total returns.
• Municipal bond yields declined. New issue supply was light at $8B, and fund inflows were $1.1B. This week's new issuance is outsized at $14.9B.

U.S. Treasury yields fell sharply on a dovish U.S. Federal Reserve meeting and softer U.S. economic data. The ISM manufacturing report fell to a level that indicates industrial contraction and the July jobs report showed a material deceleration.

Watchlist

• 10-year U.S. Treasury yields fell sharply again last week, and we expect yields to be somewhat rangebound at these levels through year-end.
• Spread sectors generally performed well, though they lagged the rally in Treasuries.
• Increased seasonal supply should provide an attractive entry point for municipal bonds.

Investment views

Rates have probably peaked for this cycle, as attention pivots toward rate cuts in response to softer growth and easing inflation.

The underlying growth outlook remains healthy thanks to strong consumer balance sheets and solid levels of business investment. This combination should keep corporate defaults low.

Risk premiums may widen further, with entry points for taxable fixed income likely to become more attractive over the coming quarters. Credit selection remains key as we search for bonds with favorable income and solid fundamentals.

Key risks

• Inflation fails to continue moderating as expected, weighing on asset prices.
• Policymakers unsuccessfully juggle fighting inflation with supporting economies still struggling to gain traction.
• Geopolitical flare-ups intensify around the world.

Investment grade corporates see best weekly performance this year

U.S. Treasury yields fell sharply last week. The 10-year yield ended 40 basis points (bps) lower at 3.79%, the biggest one-week rally since 2008. 2-year yields fell 50 bps, as the market priced in a more substantial series of Fed rate cuts. The rate decline started with the Fed meeting on Wednesday, then accelerated with softer U.S. economic data later in the week. The ISM manufacturing report fell to 46.8, near recent lows and to a level that indicates industrial contraction. The July jobs report on Friday showed a net gain of 114,000 jobs, substantially lower than expected and a material deceleration. The headline number was further dragged down by -29,000 in net revisions to prior months. The softer pace resulted in a 0.2 percentage point increase in the unemployment rate, to 4.3%, presenting broader risks of economic slowdown and recession.

Investment grade corporates gained substantially, returning 2.06% for the week, the best single week of the year. The asset class lagged the broader rally in core rates, underperforming Treasuries by 87 bps. Spread levels widened to 105 bps, the highest level of the year, as investors rushed to buy relatively safer assets in the face of higher risks of economic weakness. Inflows continued, while new issuance remained healthy at $31 billion. Those deals came with wider concessions, hitting almost 7 bps on Thursday, compared to below 4 bps overall in 2024.

High yield corporates lagged after recent outperformance, returning -0.05% for the week and underperforming similar-duration Treasuries by 156 bps. Senior loans returned -0.05% as well. Both asset classes were negatively affected by the softer economic data, while loans were also hurt by expectations for more aggressive Fed rate cuts. Loan yields implied by forward rates dropped 45 bps, the biggest one-week move since late 2022, though they still offer a very attractive yield versus other asset classes at 8.50%. On the technical front, loans saw a small outflow of -$54.4 million, while high yield had an inflow of $438 million.

Emerging markets ended mixed, returning 1.18% but lagging similar-duration Treasuries by 142 bps. Yields fell across emerging markets, but spreads widened by 26 bps for sovereigns and 22 bps for corporates. Emerging markets broadly have a shorter duration profile than investment grade corporates, but a longer profile than high yield corporates.

Municipal bond issuance continues to be outsized

The municipal bond yield curve ended lower last week. Short-term muni yields declined 17 bps, while the long end fell 18 bps. The new issue calendar was light and deals were well received. Fund inflows included $868 million into exchange-traded funds. This week's new issue calendar should be outsized. It will be a struggle to get such large volume placed without deeply discounting some deals.

Muni bonds underperformed the Treasury rally, mainly due to too much muni new issuance for the market to absorb in one week. This coming week should see a similar trend. Some deals will likely end up being pulled, and many will be priced at steep concessions to pique buyers' interest. However, we believe munis as an asset class should be well bid, following the Treasury market. Also, 01 August muni reinvestment money totaled approximately $48 billion.

New York city, New York, issued $1.1 billion general obligation bonds (rated Aa2/AA). The deal included 5% coupon bonds due in 2033 coming at a yield of 3.15%. On Friday, as the market rallied after the weak jobs report, those bonds traded at 2.84%. This is a good example of how strong the muni market rallied last week.

High yield municipal yields decreased 14 bps on average last week, lagging the decrease in long-term AAA rated muni yields. Duration has finally become a long-awaited tailwind to returns, now contributing alongside yield and credit. Investors added inflows of $222 million last week. We are tracking a rather large week of new issuance, with 15 deals offering more than $2.5 billion, a welcome development for an otherwise undersupplied market. Temporary spread widening should present a window of relative opportunity for investors taking notice of attractive returns.

Muni bonds underperformed the Treasury rally, mainly due to too much muni new issuance to absorb in one week.

In focus: The Fed says, "See you in September"

Last Wednesday, the Federal Reserve remained on pause but signaled that a rate cut may be forthcoming.

In its policy statement, the Fed highlighted that there are "risks to both sides" of its dual mandate - price stability and maximum employment - noting that inflation "has eased" but remains "somewhat elevated," while job gains "have moderated" and the unemployment rate "has moved up." The change signaled that the primacy of inflation fighting over the past two years may finally start giving way to a greater emphasis on safeguarding economic growth.

Chair Jerome Powell began his post-meeting Q&A by stating that the Fed had "made no decisions about future meetings." But in a dovish tilt, he explained "the economy is moving closer to the point at which it will be appropriate to lower our policy rate" and a rate cut "could be on the table as soon as the next meeting in September." Nonetheless, Powell specified that the rate decision still depends on "the totality of the data, the evolving outlook and balance of risks." That decision was made easier by July's jobs report, released Friday, which showed employers adding just 114,000 payrolls. Markets now anticipate roughly four rate cuts by year-end, starting next month.

U.S. Treasury yields declined in the wake of the Fed meeting and fell further following the soft labor market data. The 10-year note finished the week at 3.79%, down 40 bps.

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