YIELD CURVE REMAINS INVERTED AS INFLATION SUBSIDES

The U.S. economy has been resilient, with robust consumer spending, strong labor demand, and a buoyant national housing market that has so far avoided significant decline. In spite of this, the bond market continues to forecast an economic slowdown within the next 12 months, as the cumulative impact of U.S. Federal Reserve (Fed) interest rate hikes finally takes hold. The U.S. Treasury yield curve remains deeply inverted, with a 1-year Treasury bill yielding close to 150 basis points more than a 10-year Treasury bond. We share the bond market’s forecast regarding near-term economic growth and expect to see more signs of slowdown within the next few months.

Inflation remains elevated but the data have improved, with the U.S. Consumer Price Index 4.0% in its latest reading at the end of May. This figure remains above Fed policymakers’ long-term target of 2.0%, but is a significant improvement from 6.5% reported at the end of 2022. Inflation breakeven rates (what investors forecast inflation to be in the future) are also down, with both 2-year and 10-year breakeven rates close to 2.0% today. The potential for persistent elevated inflation remains a risk for the financial markets, but the inflationary outlook has brightened with a good chance that inflation will return to historic norms. Despite improvement on the inflation front, it’s unlikely that the U.S. Federal Reserve will relax tight monetary policy in the second half of 2023. Policymakers are under considerable pressure to ensure that inflation is stamped out for good and will likely err on the hawkish side of the policy debate unless forced by events to change tack. Stress in the banking sector complicates their analysis, but Fed leaders likely view this as collateral damage that is necessary to bring inflation under control.

There was some question early in the second quarter regarding agency mortgage-backed security (MBS) pricing in the face of forced liquidation of positions previously held by bankrupt U.S. banks. Any concern has been allayed by continued strong investor demand for the asset class and an orderly liquidation of affected MBS portfolios. In fact, agency MBS option-adjusted spreads fell during the quarter, boosting the sector versus both Treasuries and investment-grade corporate bonds. MBS remain attractive, with little of the mortgage universe facing