The rally in fixed income finally seemed to stick in Q3 with Investment Grade (IG) bonds returning 2.7% for the quarter and now up 7% ytd. The strong performance was propelled by a mid-September 25bp cut in the Fed Funds overnight rate to the 4-4.25% level that was months in the making. Soft employment data and subdued inflation readings, along with the likely nomination of a dovish new Fed Chairman, have the market expecting another ~100bps of cuts by next Summer.
This has driven the UST 10yr yield down to 4% from as high as 4.80% in January. Furthermore, IG and High Yield (HY) credit spreads are hovering near historic tights closing Q3 at +76bps and +280bps respectively, as the S&P 500 is making new record highs, up 14% ytd, and up a remarkable 35% from the low close of Q2, as this note is published. Even municipal bonds, which have lagged corporate credit, posted a strong Q3, +3.1%, as the long-end rallied.
All this should be music to investors’ ears, and our Short and Intermediate bond portfolios are benefitting from the current environment tracking nicely for returns in the 5% to 7% range for 2025, even without a further bond rally. The predicament, which is the case in most bull markets, even in boring bonds, is what’s next? There is a saying, “the windshield is bigger than the rearview mirror for a reason” and we try to ascribe to that at Meritage.
Over the last few decades, the go-to playbook in bond management when the Fed is easing has been to extend duration and to move up in credit quality. As discussed in prior quarterly letters, we believe that long-dated developed market Gov’t debt presents a real risk to capital preservation. Here in the US, we are running a $2 trillion deficit on a nearly $38 trillion debt load. This is in good times. Core CPI is running at 3.1% year-over-year. Sure, the can might continue to be kicked. Issuance can be altered, QE can be reignited, “yield-curve control” can be instituted, but is a longer-duration portfolio with the 10yr at 4% a good investment looking out the windshield currently? We are skeptical, and with plenty of company, as Central Banks are buying gold over Treasuries. Bitcoin, deemed a hedge against fiat currency, hits record highs, and the Dollar, as measured by the DXY, is down 10% ytd.
We continue to favor positioning portfolios underweight benchmark durations and are comfortable overweight credit exposure with maturities inside 5 years where there is strong free cash flow and asset value. A buoyant IG new issue market also gives us comfort in our near-maturity positions. Even in a surprise risk-off environment, with the Fed biased towards cutting overnight Rates, we would expect positive total return. The yield curve, as measured by 2-10s, has steepened about 36bps from its flattest point of 2025 to ~54bps. We believe this trend change steeper is just getting started with the current macro forces at play. A steeper yield curve reinforces our preference for positioning on the front-end. We value the flexibility our conservative positioning gives us as macro forces such as a Fed easing cycle and new tariff impacts play out.
Lastly, a couple thoughts on the Federal Reserve going forward. First, although there is no clear favorite for the Fed Chairman nomination, Director of the National Economic Council, Kevin Hassett, has edged up in the prediction markets. We believe it is a two-horse race between Hassett and Fed Governor Christopher Waller, and lean towards President Trump nominating Hassett given he is a current cabinet member and Fed outsider. Both are intelligent, qualified candidates, in our view. Trump’s decision is expected by Thanksgiving, but no date is set.
Second, on the hot topic of “Fed Independence”, we are squarely in the camp that it is important. However, while Trump’s opinions on interest rates have been predictably louder than past Presidents, political pressure is nothing new. Further, we do find some irony in that the Fed of the past couple of decades that brought us Zero Interest-Rate Policy (ZIRP), all sorts of mission creep, including a balance sheet that ballooned to $9 trillion and purchases of corporate bonds, let alone 9% inflation, now has its hawkish guard up perhaps due to partisan politics. Alas, we would prefer the Trump Administration focus on reigning in spending and truly pro-growth policies rather than push for slashing overnight rates while the average American is still struggling with price levels of basic necessities. Additionally, long-end rates, including mortgage rates, may not move down dramatically with hefty Fed Funds cuts. Sound fiscal and monetary policy will go a lot further in decreasing borrowing costs in the long-run than simply cutting the overnight rate.
Thank you for your trust in navigating an ever-changing macro environment.
