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March 31, 2022 — Market Insights
Market Review

Covid Gives Way to Ukraine/Russia Conflict...

  • Thankfully, the omicron variant of COVID-19 proved to cause less severe disease generally than previous strains. By the end of January, the tide seemed to turn with daily infections falling rapidly and many remaining restrictions removed in rapid fashion by early March.
  • With COVID concerns fading to the background somewhat, rising geopolitical tensions in Europe took center stage during the quarter. Russia invaded Ukraine on February 24, and the U.S. and its allies have responded with unprecedented economic sanctions. The impacts of these actions have reverberated through financial and commodity markets.
  • GDP growth rebounded to a 6.9% q/q annualized pace in 4Q21, exceeding expectations despite the effects of the omicron variant on consumption. Still, headwinds persist and estimates for 1Q22 GDP are in the 0.5%-1.5% q/q annualized range while estimates for the full year are in the 3.0%-3.5% range.

…With Economic Recovery Intact for Now

  • The labor market has been strong, as job growth handily exceeded expectations in January and February, with 504k and 750k jobs added respectively. March saw another 431k jobs added, just slightly below expectations. Further, consistent upward revisions going back to October indicate the labor market is even stronger than previously thought. As it stands, total employment is now only about 400k jobs less than pre-pandemic levels.
  • After a curtailed holiday spending season as a result of the omicron variant surge and supply chain bottlenecks, retail sales came in at 4.9% m/m and 0.3% m/m in January and February respectively. However, with inflation running hot, the University of Michigan Consumer Sentiment Index slipped to just 59.4 in March, the lowest reading since 2011.
  • The ISM manufacturing and services indices have fallen from the historic highs realized in 2021; however, both remain solidly in expansionary territory. The ISM Manufacturing PMI came in at 57.6 in January, 58.6 in February, and 57.1 in March, while the ISM Services PMI measured 59.9 in January, 56.5 in February, and 58.3 in March.

Fed Begins to Raise Rates

  • At the start of the year, the Fed left rates unchanged at its January meeting and kept the previously accelerated QE taper plan on track for completion in March. Furthermore, the Summary of Economic Projections (SEP) from the December meeting indicated that FOMC members projected two to three rate increases in 2022.
  • Fast forward to the March meeting, the Fed raised its policy rate by 25 bps. Additionally, the updated SEP now indicates that the FOMC intends to raise rates six more times in 2022 (at each remaining policy meeting).
  • There was considerable debate leading up to the March meeting about the possibility of a 50 bps move vs. 25 bps to get things started. While this did not happen, the median dot plot suggests that there could be accelerated rate hikes at some point. Chair Powell and several other FOMC members have already indicated that the Fed will increase rates more quickly if necessary.

...With Inflation at Record Highs

  • Headline CPI increased 7.9% y/y and 0.8% m/m in February, while core CPI increased 6.4% y/y and 0.5% m/m. These readings mark the highest rates of inflation in 40 years. Similarly, headline PCE increased by 6.4% y/y in February – also the highest since 1982 – while core PCE increased by 5.4% y/y – the highest since 1983. Alternative measures of core inflation also remain elevated.
  • The 5-year and 10-year break-even inflation rates of ~3.4% and ~2.8% respectively are close to the highest measures on record since the inception of the TIPS market in the late 1990s. Still, the 5Y-5Y forward break-even inflation rate remains firmly anchored at 2.4%, suggesting that the market believes the Fed will act aggressively enough to squelch the inflation bubble.
  • Sustained inflationary pressure has resulted in a compressed timeline for monetary policy action, and the market is bracing for the Fed to remove accommodative monetary policy faster than previously thought.

Fed Hike Flattens Curve, Spread Sectors Underperform Treasuries

  • The yield curve continued to reshape during the quarter as the market re-priced inflation fundamentals and an increasingly hawkish Fed tone. The 2-year Treasury sold off by 161 bps (1.61%), while the 10-year Treasury sold off by 83 bps (0.83%), such that 2s vs. 10s ended the quarter essentially flat. Notably, 2s vs. 10s has been inverted since the end of March. Meanwhile, 10-year real rates sold off by another 65 bps to -0.45%.
  • Most major fixed income spread sectors underperformed like-duration Treasuries during the quarter, led by investment grade Corporate bonds. Within IG Corporates, longer bonds meaningfully underperformed short/intermediate maturities, while A/BBB issuers lagged the highest quality names.
  • Corporate spreads weakened across maturities during January and February before retracing somewhat in March. Since the end of the year, spreads roughly have moved back to historically wide levels. Despite wider spreads and broad market volatility, new issue supply remains robust and demand remains elevated.
  • The Agency MBS sector had another tough quarter in the face of an increasingly hawkish Fed. With interest rates moving higher, the negative convexity of Agency MBS was on full display throughout the quarter. Primary mortgage rates have increased considerably, thereby reducing the refinancing incentive for most borrowers.
  • ABS also underperformed Treasuries in 1Q, as pending monetary policy actions pressured short spreads. New issue supply was $71 billion in the first quarter with auto ABS leading the way (Citi). Consumer credit performance continues to be strong; however, the taxing effect of elevated inflation may drive some credit deterioration, particularly at the lower end of the quality spectrum.
  • Despite ending the quarter on a more positive note, CMBS also underperformed for the full three-month period. New supply started the year off strong with almost $29 billion: $10 billion of conduit issuance and $19 billion of SASB (BoA). CMBS credit performance continues to improve as some of the hardest hit property types, such as hotel and leisure, continue to benefit from the removal of pandemic restrictions.