Fed May Do Little in This Push-Me-Pull-You Market

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Karen Manna Vice President Investment Director

It’s become a cliché but bond markets remained volatile in May, with investors ultimately discounting the latest tariff tantrums and re-embracing risk. Treasury yields spiked once again as the federal budget and deficit took center court, but this time other forms of fixed income investment (asset-backed, corporate, international and municipals) benefitted by comparison to their associated risk-free rates. On a year-to-date basis, the Bloomberg Universal Bond Index—which includes high yield and emerging markets—is outperforming the IG-only Bloomberg Aggregate.

The push/pull response of markets to economic data has made the month-to-month interpretation of prints on inflation and GDP tricky. Recession expectations, which accelerated with the early April Liberation Day drama, have cooled. Even if recent inflation signals weaken, uncertainty is not going away, as tariffs could/should/would propel prices higher and noise around unemployment continues. The DOGE operations have faded from the headlines and companies are holding on to employees. Does that change? And if it does, is it gradual or sudden?

FOMC meeting minutes were released on May 28 with no significant surprises and the committee maintaining a cautious approach in its pursuit of its dual mandate. Markets anticipate two cuts this year, but that’s a relatively benign forecast that awaits the emersion of a trend.

Treasurys bear the brunt

US Treasury notes and bonds faced a Wall of Worry over recent weeks as policy uncertainty, not only on trade and tariffs but also on the budget and deficit, pressured yields. May saw yields increase 29 basis points for the 2-year, 24 basis points for the 5 and 10-year, and 25 basis points in the 30-year portion of the curve. The yield curve can continue to steepen in the long run, with several potential drivers:

• An overall increase based on elevated inflation expectations. 
• Concerns around the growing federal deficit (bond vigilantes).
• A further retrenchment in the “end of US exceptionalism” trade.

Auctions of 2-,5-, and 7-year notes, however, have gone well, with strong demand and pricing better than expected. This was a relief after an underwhelming 20-year auction prior to Memorial Day weekend and a poor 40-year Japanese government bond auction.

Credit sectors pick up the slack

For the most part, credit sectors continue to tighten in from the widest spread levels achieved around Liberation Day but still are not at the extreme tight spreads of late last year. Investment-grade corporates continue to perform well amid strong supply met with reasonable demand. Spreads at the end of May were 88 basis points with a yield-to-worst (YTW) of 5.21%. and technical factors are favorable. High yield bonds saw spreads at 315 basis points, tighter by 69 over the month and a YTW of 7.46%. Emerging market debt also continues to fare well amid a global easing cycle as many investors reconsider their reliance on the US to include allocations to international and emerging markets alike.

The Federated Hermes Currency Management Committee continues to be underweighted to the US dollar as a tactical and strategic position. Over the longer run, the majority of the Committee expect the dollar to decline but not be a smooth line. Moments of strength may provide opportunities to express their conviction.

In other bond news…

President Trump addressed the fates of Fannie Mae and Freddie Mac in a social post discussing the possibility of bringing the entities public after more than a decade in conservatorship. Some estimates value the two entities at more than $380 billion, which could net the US Treasury more than $300 billion. This would also be a complex and lengthy process with potential pluses and minuses:

• Trump indicated the government would continue providing guarantees and oversight, and markets would likely prefer that to be the case.
• The prospect of raising this cash helps with the budget and fiscal hawks in Congress.
• The shift in structure, if not executed well, has the potential to put upward pressure on mortgage rates, which would not be beneficial.

From an investment perspective, we at Federated Hermes continue to invest in MBS with a focus on near-term valuation and volatility rather than the possibility of privatization. Treasury Secretary Bessent revealed the debt ceiling X-date would occur in mid-August, and likely spur the Senate to act on the budget bill by the end of June in order to avoid a true crisis by solving the issue with at least a month to spare.

• The current debt ceiling is $36.1 trillion and Treasury’s cash on hand stands at roughly $600 billion.
• Treasury recently reduced the size of its planned four- and eight-week offerings as it works to preserve room under the statutory debt ceiling.
• Things could get tight as boosts from tax payments in mid-June and tariff revenues make a big difference (and particularly if a court ruling requires tariff refunds).
• Average spending is about $30 billion per day, but expenditures are variable and not smooth as portrayed by an average.

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Bond prices are sensitive to changes in interest rates and a rise in interest rates can cause a decline in their prices.  In addition, fixed income investors should be aware of other risks such as credit risk, inflation risk, call risk and liquidity risk.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Investment-grade securities are securities that are related at least "BBB" or unrated securities of a comparable quality.

Bloomberg US Universal Index: Is an index that represents the union of the US Aggregate Index, US Corporate High-Yield, Investment Grade 144A Index, Eurodollar Index, US Emerging Markets Index and the non-ERISA eligible portion of the CMBS Index. The index covers USD denominated, taxable bonds that are rated either investment grade or below investment grade.

Bloomberg US Aggregate Bond Index: An unmanaged index composed of securities from the Bloomberg Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. Indexes are unmanaged and investments cannot be made in an index.

Yield to worst (YTW): On a corporate bond, the yield to worst is the lowest yield that a buyer can expect among the reasonable alternatives, such as yield to maturity, yield to call, and yield to refunding.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

The value of some mortgage-backed securities may be particularly sensitive to changes in prevailing interest rates, and although the securities are generally supported by some form of government or private insurance, there is no assurance that private guarantors or insurers will meet their obligations.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks and may be more volatile than investment-grade securities.

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