A durable case for duration

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Is the Fed’s inflation-fighting epic nearing its final chapter? The magical book at the center of 1980s fantasy film The Neverending Story tells the tale of a young warrior who battles the Nothing, an evil force intent on destroying the land of Fantasia. A similar title and plot summary could easily apply to U.S. Federal Reserve Chair Jerome Powell and his fellow policymakers’ relentless quest to stamp out the scourge of inflation. Of course, inflation isn’t “nothing,” and the potential collateral damage from the Fed’s aggressively hawkish monetary policy — namely, a possible recession — might bring this very real economic story to a less-than-happily-ever-after conclusion.

But while investors have been preparing their portfolios since early 2022 against the so-called “most anticipated recession of all time,” the dreaded downturn has yet to materialize. In fact, market expectations currently favor a soft-landing narrative amid recent disinflationary trends and signs of gradually diminishing consumer strength, such as heavier debt loads (Figure 1). And August employment data revealed a slowdown in hiring, fewer job openings and an uptick in the unemployment rate, driven by an increase in the labor force participation rate. These factors collectively support the argument for an imminent pause in Fed rate hikes

An inflation epilogue or sequel could complicate the story. Our base case scenario continues to call for (1) one more 25 basis points (bps) rate increase in this cycle, either at the Fed’s September or November meeting (we lean toward the latter), after which we expect policy rates to remain stable but elevated, likely through the end of next year; and (2) a soft landing or mild recession sometime in 2024. The plot could thicken if climbing oil prices continue, driving a rebound in overall inflation and prompting a vigilant Fed to hike more than once in the near to medium term.

Portfolio considerations

Given our perspective on moderating inflation and Fed policy, we believe yields — including the bellwether 10-year U.S. Treasury yield — have likely peaked for this interest rate hiking cycle. The 10-year yield has typically peaked within the last few months before a final Fed rate increase, which in this case we anticipate will occur no later than the first day of November. This backdrop informs our view that investors should consider closing duration underweights in taxable fixed income.

One way to do this is by adding to investment grade corporate bonds, which have relatively longer durations than the broader fixed income market. They are also currently yielding close to 6%, and defaults are expected to remain low. We also favor selectively taking on risk in other credit sectors like senior loans, emerging markets debt and preferred securities, although duration in these categories is lower than in corporate bonds.

In the municipal bond space, we prefer a modestly overweight duration position, supported by an upward-sloping yield curve (Figure 2). AAA municipals are yielding more than Treasuries on a tax-equivalent yield basis across the curve. Additionally, we see attractive opportunities within the “up-in-quality” part of the municipal high yield market, which also offers longer duration. We expect credit spreads in this segment to remain stable, with defaults unlikely to rise in the medium term. BBB rated municipals are yielding about 2.5% more than their AAA municipal counterparts across short- and long-term maturities, which we find compelling.

Muni fundamentals remain sound. Rainy day funds (savings/reserves) for municipalities, for example, sit at historic highs. State governments are entering fiscal year 2023 with $159 billion in rainy day funds, more than double their pre-pandemic level, offering significant budgetary flexibility. At the same time, a weak issuance calendar should keep muni supply low, a supportive technical for the asset class.

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