Market & Performance Summary

The end of the second quarter brought further evidence of a “Goldilocks” scenario unfolding for the Federal Reserve (the “Fed”) with growth moderating and inflation slowing. This scenario holds the potential to provide broader market support, as it creates room for the Fed to cut policy rates. However, both the timing and pace of Fed rate cuts remain contentious for investors.

At the Federal Reserve’s June policy meeting, the “dot plot” indicated just one rate cut this year, a reduction from the three cuts projected in March. Federal Open Market Committee (“FOMC”) members now expect the fed funds rate to fall near 5% at the end of this year and to 4% at year-end 2025. Consistent with recent history, the recalibration has been a function of stickier than expected inflation. Core inflation is now expected to be 2.8% at the end of 2024 and 2.3% at the end of 2025, versus 2.6% and 2.2% previously.

FOMC’s Chair Powell emphasized that the decision between one cut and two this year was a close call and both outcomes are still plausible. With housing costs comprising a third of the Consumer Price Index, Powell made a point to highlight a national housing shortage, noting that rents could take "years" to slow down to pre-pandemic inflation rates. He avoided suggesting further interest rate increases, stating that if inflation remains high, the FOMC would maintain the current rate level indefinitely.

Fixed income, as an asset class, struggled in the first half of the year. With interest rates across the yield curve grinding higher, price declines have offset income generation, leaving most major fixed income benchmarks roughly flat for the year. The silver lining is that lower prices and higher yields increase future return expectations. The yield on the widely quoted US Aggregate Bond Index stands at 5%[1].

As we head into the summer months, key market trends include declining inflation and interest rate expectations, contributing to a broadening equity market rally. We have found this to be a prudent time to rebalance portfolios to capture gains in riskier assets while mitigating downside risks within fixed income. While returns on cash are expected to gradually decline, market pricing of futures contracts tends to underestimate the speed of cuts once the cycle turns. Therefore, we advise investors to lock in yields at currently attractive levels in quality corporate and municipal bonds.

Navigating an Inverted Yield Curve

July 6th will mark the second anniversary of the day 10-year Treasury yields fell below 2-year rates in this rate cycle. This inversion is officially the longest in recorded history, breaking a record held since 1978. The recessionary signals of an inverted yield curve have long intrigued macroeconomists and investors. However, we believe the direct implications for fixed income investors warrant even greater attention.

As a refresher, yield curves are generally upward-sloping, reflecting that lenders demand extra compensation for longer-term loans due to increased uncertainty. An inverted yield curve—where short-term rates are higher than long-term rates—is uncommon, occurring only 10% of the time over the prior four decades. This inversion suggests investors expect the Fed to cut rates to stimulate a sputtering economy, implying that future rates will be lower than current rates.

An inverted yield curve is viewed as a strong signal that the economy may be heading for a recession. Indeed, a yield curve inversion has preceded every recession since the 1970s. Despite significant concern about the yield curve over the last few years, the US economy appears to be functioning reasonably well, but the yield curve has remained stubbornly inverted.

Figure 1: Inverted Yield Curve: 10-Year Treasury Constant Maturity Minus 2-Year Treasury-Constant Maturity

Disclosure: Shaded-areas indicate U.S. Recessions

Campbell Harvey, the economist most associated with the inverted yield curve, has argued that the economy could avoid a recession this time, noting, “It is naive to think that you can just forecast the complex U.S. economy with a single measure from the bond market.” Instead of relying on a single datapoint to forecast the broader economy, we believe it's more productive to examine the direct impact of the yield curve on fixed income investors.

In short, we do not believe this inversion warrants a shift in fixed income strategy for several reasons, each bolstering the case for maintaining the current course:

· Yields in the high-grade bond market still offer reasonable compensation for extending beyond short-duration bonds, ensuring adequate returns for slightly longer commitments. For example, we’re able to achieve similar yields on new purchases of 8-year municipal bonds, which is the long end of our municipal bond ladders, as we can on 2-year municipal bonds.

· Cash yields could diminish rapidly if disinflationary trends persist. The fed funds rate is projected to drop to 4% by the end of 2025, and historically, rate forecasters have underestimated the speed of rate cuts once they begin. Reinvestment risk, or the risk that bond maturities will need to be redeployed at lower rates, is a concern that most investors overweight shorter maturities are not seriously considering in the current environment.

· Absolute bond yields are attractive on several levels. Historically, the 5.4% yield offered on intermediate corporate bonds ranks in the 80th percentile of yields over the last two decades.[2] This yield level also provides sufficient protection against earnings erosion from the expected 2.3% inflation over the next five years.[3]

· Corporate and municipal bonds have historically performed well after peak inversion, as investors flock to quality during times of distress. After inversion peaks, the high-grade debt markets tend to excel, occasionally generating outsized returns as longer-term bond yields fall, enhancing the attractiveness of high-grade bonds in the current environment.

Figure 2: Corporate Bonds Perform Well Post-Inversion Peak

Source: Macrobond. 2s/10s Inversion is when the yield on the 2-year Treasury exceeds the yield on the 10-year treasury. The corporate index shown is the Bloomberg US Corporate Bond Index. Returns are calculated monthly in the 12-month period following the point of peak inversion. An investment cannot be made in an index. Past performance is not a guarantee of future results.

Ultimately, given the current yield curve inversion, securing attractive yields across the maturity spectrum offers a more prudent and diversified approach compared to chasing potentially short-lived opportunities at the short end of the curve.

Conclusion

The high-grade fixed income market endured a challenging first half of the year, with rising yields and persistent economic concerns. Despite the current inversion of the yield curve, we believe it does not necessitate a significant shift in fixed income strategy. Attractive yields in the municipal and corporate bond markets, combined with the historical performance of high-grade debt post-inversion, provide compelling reasons to maintain current positions.

As we enter the second half of the year, we believe that active bond management remains crucial in response to the continually evolving economic indicators and Federal Reserve actions. Fixed income remains a vital component of a well-diversified investment strategy, and navigating the nuances of the current market environment will be key to achieving long-term financial goals.

[1] Measured using yield-to-worst on the Bloomberg US Aggregate Bond Index.

[2] Measured using yield-to-worst on the Bloomberg Intermediate Corporate Index.

[3] Measured using breakeven rates on US Treasury bonds.

DISCLOSURES

Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. The information and opinions expressed in this publication are not intended to constitute a recommendation to buy or sell any security or to offer advisory services by Kovitz. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to participate in any trading strategy, and should not be relied on for accounting, tax, or legal advice. This report should only be considered as a tool in any investment decision matrix and should not be used by itself to make investment decisions.

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Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.