July Outlook
July 18, 2023  |  By Hank Cunningham

Inflation remains the key bond market driver. There has been significant improvement in headline inflation, while the important core rates and the Fed’s preferred rate – core PCE – remain stubbornly high. Meanwhile, the employment market, consumer confidence and the housing market are buoyant. This seals the likelihood that the Fed will go ahead with another 25-basis point hike in its Fed Funds rate at the July 26 FOMC meeting.

The key question is whether the tightening phase will end then. To be sure, we are closer to the end of the tightening cycle, but it is premature to expect central banks, most notably the Fed, to consider easing for the balance of the year. It is possible we have seen a double-top in 10-year yields at 4% while short-term yields may be pushed even higher, producing even more inversion in the yield curve. The emergence of a serious credit contraction would materially change this outlook. In the meantime, corporate bond markets, both investment-grade and high-yield, have been well behaved, narrowing meaningfully from Government bond yields. Cracks are showing in the taut labour market, and manufacturing has weakened significantly. However, consumer confidence has improved greatly along with retail sales.

There are few signs of global inflation subsiding sufficiently to allow central banks to contemplate easing monetary policy. For inflation to even reach 3% seems optimistic. Thus, central banks will likely retain their restrictive stances for the balance of the year. Inflation will remain the overriding concern and with some recent setbacks in core inflation, both in North America and overseas, it is possible that bond yields will move higher. However, it is more likely that the 10-year yield will continue to fluctuate in a range centered around 3.75%, with 4.25% a possible high.

Consumer confidence has rallied which flies in the face of recession fears. Fed tightening over the past 16 months is working its way through the system. The market must also deal with the $2.1 trillion dollar budget deficit. Combined with Quantitative Tightening (QT) to the tune of $95 billion per month, this portends higher bond yields. Despite optimism among pundits, there are no signs that the Fed will lower its key interest rate this year. Whenever this tightening cycle ends, the Fed will likely also end its QT program.

The yield curve has inverted further, following the latest FOMC deliberations, with the spread between two- and 10-year Treasurys now at negative 100 basis points. In the meantime, fixed income investors are facing only modest returns for this year after last year’s record negative returns.

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