The Debt Ceiling's Done, but the Turmoil Isn't

What's Driving Markets...

1. The debt ceiling (and the uncertainty it caused) was an incredible market distraction during the month of May. The prospect of default was low probability but high impact, thus the debt-ceiling resolution took a major tail risk off the table for 2023 and beyond. The outcome from negotiations is a small, rather marginal deal that may negatively impact GDP by an estimated 40 basis points¹ (bps).

The next looming issue is refilling the Treasury General Account (TGA), which was depleted during debt-ceiling negotiations as the Treasury was forced to reduce issuance. Typically, the TGA maintains several hundred billions of dollars in liquidity and, in most cases (around 90% of the time), has enough proceeds to cover at least one week’s worth of Treasury payments without market access.²

With the debt ceiling behind us, the Treasury needs to refill its account to the approximately $600 billion-$700 billion buffer zone that adheres to its liquidity policy. This could equate to $1 trillion+ issuance of Treasury securities, primarily in T-bills. This issuance is a form of liquidity withdrawal, but it may not be equally distributed throughout the system. For example, if the proceeds for T-bill purchases come primarily from holders of bank deposits, then overall funding for the banking system would be reduced (and could add strain into a banking system that is already dealing with deposit flight).³

However, if the majority of Treasury bills are purchased by money-market funds, the likely impact is a net reduction in the money-market funds usage of the Federal Reserve (Fed)’s reverse-repo (RRP) facility,⁴ which existed to soak up excess funds held by those entities (now, those money-market funds would instead purchase newly issued T-bills).

In this case, the expected tightening impact is somewhat mitigated. Why? Because in the reverse-repo facility, money-market funds are already lending proceeds to the Fed. If they purchase T-bills, the proceeds would instead go to the Treasury, which would lead to a functionally similar outcome … namely, that they have been drained out of the system in both cases and there shouldn’t be a net additional impact.

The range of estimates we’ve seen in terms of the impact on the RRP usage by the new Treasury issuance is 0.4% to 0.9% (which means the market doesn’t have a consensus). However, any number less than 1 means that there is less liquidity in the market going forward this year, which should be a headwind to financial conditions. This dynamic could be the single most important driver of fixed-income market conditions this year, so we’ll continue to watch it closely.

Fixed Income

3 Reasons to Examine Your Cash Allocation

Investors are finally getting paid for holding cash, but there are risks in holding too much of it.

Liquidity could be the single most important driver of fixed-income market conditions this year.

FIGURE 1

Reverse Repo and Treasury General Account Amounts ($ billions)

As of 5/31/23. Source: Federal Reserve Bank of New York.

2. Market positioning has taken an interesting turn in the last few months. Currently, there's a substantial short position in US Treasuries via futures⁵ (see FIGURE 2 left). According to market chatter, much of this short is hedge-fund positioning for basis trading (taking advantage of the differential in implied financing rates on futures vs. repo in US Treasuries), but it’s still an impressively sized position for levered⁶ participants. However, balancing that out is the steady gain in long positions by asset managers (FIGURE 2 right). Asset managers generally have steadier hands and are less likely to be “pushed” out of their positions by market volatility.

FIGURE 2

Hedge Funds Are Going Short While Asset Managers Are Going Long

Commodity Futures Trading Commission
(10-Year Futures Positioning)

Asset Managers' Net Treasury Futures

As of 5/23. Source: Bloomberg and CFTC.

3. Economic data appeared mixed as the labor market and inflation held firm, while manufacturing sector weakness portends recession. The US consumer continues to prove resilient in the face of persistent inflation, as both personal income and spending rose. Non-farm payroll growth surged ahead of expectations during May, though the unemployment rate rose to a seven-month high of 3.7%.⁷ Manufacturing, however, has been mired in contractionary territory since November—an indicator of impending recession—and is likely to remain weak in the months ahead given tighter financial and credit conditions. China’s manufacturing Purchasing Manager's Index⁸ also contracted, driven by declines in factory output and new orders. Overall, China’s re-opening has been somewhat disappointing. Eurozone inflation decelerated, but is still elevated at 7%, while the unemployment rate there fell to a record low of 6.5%.⁹

FIGURE 3

Unemployment Rates (%)

As of 5/31/23. Source: Bloomberg.

The Fed voiced little concern about banking stress and made no mention of slowing quantitative tightening.

4. The Fed hiked rates again in May but indicated it could pause or skip in June. The Fed hiked rates by 25 bps but indicated it would take a more data-dependent approach to policy going forward. Markets interpreted this as a signal the Fed could pause its tightening campaign in June, a notion reinforced by Chair Jerome Powell is his post-meeting press conference. At the same time, Powell threw water on any hopes of pivoting to rate cuts since inflation still has a way to go to reach the Fed’s 2% target. The Fed voiced little concern about banking stress and made no mention of slowing quantitative tightening, signaling that it views the financial system as having ample reserves.

5. Bank of Japan (BOJ) and Japan’s Ministry of Finance both had important communications. The newly appointed Governor of the Bank of Japan, Kazuo Ueda, has stated that he doesn't believe inflation hasn't hit a sustainable level yet. This eases market concerns about an immediate end to Japan’s low interest rate environment, which is driven in part by the BOJ’s control of the Japanese government bond yield curve.¹⁰ Additionally, the Ministry of Finance in Japan dropped hints that further yen weakness might result in a foreign-exchange intervention to stabilize against further cheapening.

6. Credit-rating trends, a leading indicator for defaults, have been deteriorating over the last few quarters driven primarily by lack of upgrades. Corporate fundamentals generally look strong because most companies are well-capitalized and leverage overall remains manageable. We expect credit metrics to deteriorate at the margin, and weaker credits could experience reduced access to financing, particularly as banks tighten their lending standards. We forecast defaults will increase, but to around their long-term averages of 4-5% as opposed to a full-scale default cycle.

FIGURE 4

Credit-Rating Trends

As of 5/31/23. Source: Bloomberg and Moody's.

7. The Department of Energy has committed to purchasing 3 million barrels of sour crude oil as part of their plan to refill the Strategic Petroleum Reserve. This is a strategy to provide some form of a floor in US petroleum production, allowing companies to keep capacity online (vs. shutting down due to weaker expected prices). It’s part of the slow, cumbersome process of beginning a corridor system for domestic crude: sparing the economy some of the volatility that goes with a purely free-floating oil-price mechanism.

What’s Keeping Us Up at Night…

1. The TGA refill: While this might be beating a dead horse given the level of detail earlier, it’s still something that keeps us up at night. This large-scale increase in bill issuance will take place against a backdrop of ongoing quantitative tightening of $95 billion per month.

2. Ukraine/Russia: The heavily telegraphed Ukrainian counter-offensive is expected to begin at any moment. Moreover, there have been several incursions in the Belgorod region of Russia indicating an expansion of the geographic footprint of the conflict. The damage to a Ukrainian dam also signals, according to our geopolitical strategists, continued escalation of the conflict.

3. Tension in the Balkans: Kosovo is about to receive 700 additional NATO troops to stabilize tensions in the north. This situation bears watching given tensions in the region and the fact that 30 NATO troops have already been injured during demonstrations and clashes. Markets aren't currently factoring in renewed instability in the Balkans as a risk.

4. Everyone is piled in short-term bills: While this doesn’t keep us up at night, we find that if forwards are realized in the front end (and yes, that doesn’t always happen), that attractive 5.35% yield collapses to 3.8% ... one of the widest spreads¹¹ in recent history between spot (real-time rates) and forward (agreed upon for a future sale) bill rates. While everyone knows that the bill yields we see are annualized, markets don't seem to have fully internalized this.

Investment Implications

We continue to think that we're in the right environment for global sovereign and currency strategies to shine: from a total-return perspective, a risk-diversifier approach, and a soundness perspective. This is another, more diversified approach to monetize the ongoing and expected volatility of global capital markets.

Given the overall slowdown in some sectors of the economy, it may also start to make sense to consider CORE/CORE+ positions¹² as we approach the end of the tightening cycle. The sell-off in dollar rates, rising geopolitical risk, and slowing economy may make higher-quality fixed income attractive from a recessionary perspective, as well as for a positive relationship between bond prices and bond yields. While inflation surprises still exist, a large portion of the move in rates has likely already occurred, providing substantial wiggle room and carry¹³ in case of upside inflation surprises.

Shorter-duration¹⁴ credit has paid well given the ongoing volatility and uncertainty in markets. For low-risk appetite thresholds, the opportunity cost of this approach has diminished substantially over the last several months, and the “higher for longer” approach would be indicative of robust carry.

Securitized credit¹⁵ may be able to mitigate rate volatility with attractive risk-adjusted spreads. Senior parts of the capital structure, in particular, seem attractive in case the cycle turns faster than expected.

FIGURE 5

Fixed-Income Sector Excess Returns

As of 5/31/23. Past performance does not guarantee future results. Excess returns are greater than the projected market rate of return. Indices are unmanaged and not available for direct investment. See below for representative index definitions. Sources: Bloomberg, JP Morgan, Wellington Management.

FIGURE 6

US Yields (%)

As of 5/31/23. Past performance does not guarantee future results. Source: Bloomberg

FIGURE 7

Fixed-Income Spreads (bps)

As of 5/31/23. US IG Corp is represented by the Bloomberg US Corporate Bond Index; US HY Corp is represented by the Bloomberg US Corporate High Yield Index, EMD is represented by the JP Morgan EMBI Plus Index, Bank Loans are represented by the LSTA Leveraged Loan Index; and MBS is represented by the Bloomberg US MBS Index. See below for representative index definitions. Sources: Bloomberg, JP Morgan, Morningstar LSTA.

To learn more about opportunities in fixed income, please talk to your financial representative.

¹ A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed-income security.

² In 2012, Super Storm Sandy caused considerable damage to New York and the northeast. The Treasury Department became concerned that during a severe exogenous event, the primary dealer community would be unable to participate in auctions but Treasury would still remain obligated to make good on its statutorily mandated payments. Hence, the development of the TGA buffer to make sure that Treasury could meet its obligations.

³ There is nuance here as well. If the proceeds are coming from depositors at large, deposit-heavy banks such as JP Morgan who are already flush with liquidity, then the impact would be more muted.

⁴ In a reverse repo transaction, a security is sold with an agreement to repurchase that same security at a specified price at an agreed upon time in the future. The difference between the sale price and the repurchase price implies a rate of interest paid by the Federal Reserve on the transaction.

⁵ Bond futures are financial derivatives that obligate the contract holder to purchase or sell a bond on a specified date at a predetermined price.

⁶ Levered investors seek higher returns by using borrowed money, which exposes them to higher risk.

⁷ Source: Bureau of Labor Statistics.

⁸ Purchasing Managers' Index (PMI) is an indicator of the economic health of the manufacturing sector. A reading above 50 signals economic expansion; below 50 signals contraction.

⁹ Source: Eurostat.

¹⁰ Yield curve is a line that plots interest rates of bonds having equal credit quality but differing maturity dates; its slope is used to forecast the state of the economy and interest-rate changes.

¹¹ Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.

¹² Core funds typically invest in a baseline of investment-grade bonds such as government, corporate, and securitized debt. Core plus funds can take that baseline and add additional sectors such as corporate high-yield, emerging-market debt, or non-US currency exposures to enhance returns.

¹³ Carry is the difference between the yield on a longer-maturity bond and the cost of borrowing.

¹⁴ Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

¹⁵ Securitized credit involves pooling a large number of loans into an investable asset. Examples include mortgage-backed or asset-backed securities.

Global Aggregate is represented by the Bloomberg Global Aggregate Index, a broad-based measure of the global investment-grade fixed-rate debt markets. Euro Aggregate is represented by the Bloomberg Global Aggregate Index - European Euro, which includes fixed-rate, investment-grade Euro denominated bonds. UK Aggregate: Bloomberg Global Aggregate Index - United Kingdom which includes fixed-rate, investment-grade sterling-denominated bonds. US Aggregate: Bloomberg US Aggregate Bond Index is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index. US Fixed MBS: Bloomberg Agency Fixed-Rate MBS Index tracks fixed-rate agency mortgage backed passthrough securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). US CMBS: Bloomberg CMBS ERISA Eligible Index, which measures the performance of investment-grade commercial mortgage-backed securities, which are classes of securities that represent interests in pools of commercial mortgages. The index includes only CMBS that are Employee Retirement Income Security Act of 1974. US ABS: Bloomberg Asset-Backed Securities Index, the ABS component of the Bloomberg US Aggregate Index, which has three subsectors: credit and charge cards, autos, and utility. US IG Corporates: Bloomberg US Corporate Bond Index covers all publicly issued, fixed rate, nonconvertible, investment-grade debt. US Corporates Aaa: Bloomberg Aaa Corporate Index designed to measure the performance of investment-grade corporate bonds that have a credit rating of Aaa; US Corporates Aa: Bloomberg Aa Corporate Index; US Corporates A: Bloomberg A Corporate Index, designed to measure the performance of investment-grade corporate bonds that have a credit rating of Aa; US Corporates Baa: Bloomberg Baa Corporate Index; designed to measure the performance of investment-grade corporate bonds that have a credit rating of Baa; US High-Yield Corporates: Bloomberg US Corporate High Yield Index is an unmanaged broad-based market-value-weighted index that tracks the total return performance of non-investment grade, fixed-rate, publicly placed, dollar denominated and nonconvertible debt registered with the Securities and Exchange Commission. Global IG Corporates: Bloomberg Global Credit - Corporate Index is an unmanaged index considered representative of fixed rate, non-investment grade debt of companies in the US, developed markets, and emerging markets. Emerging-Markets Debt: Bloomberg Emerging Markets Hard Currency Index includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Bank Loans: LSTA Leveraged Loan Index, which is a market-value-weighted index that is designed to measure the performance of the US leveraged loan market based upon market weightings, spreads, and interest payments. JP Morgan Emerging Markets Bond Index Global Index is a broad-based, unmanaged index which tracks total return for external currency denominated debt (Brady bonds, loans, Eurobonds and US dollar-denominated local market instruments) in emerging markets. Bloomberg US MBS Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

“Bloomberg®” and any Bloomberg Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Hartford Funds.Bloomberg is not affiliated with Hartford Funds, and Bloomberg does not approve, endorse, review, or recommend any Hartford Funds product. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to Hartford Fund products.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Mortgage-related and asset-backed securities’ risks include credit, interest-rate, prepayment, and extension risk. • Loans can be difficult to value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets. • Mortgage-related and asset-backed securities’ risks include credit, interest-rate, prepayment, and extension risk. • Investments in the commodities market and the natural-resource industry may increase liquidity risk, volatility and risk of loss if adverse developments occur. • Diversification does not ensure a profit or protect against a loss in a declining market.

The views expressed herein are those of Wellington Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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