It’s become a cliché but bond markets remained volatile in May, with investors ultimately discounting the latest tariff tantrums and re-embracing risk. US Treasury yields spiked once again as the federal budget and deficit took centre 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.
US Treasury yields spiked once again as the federal budget and deficit took centre court
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 Department of Government Efficiency (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?
Federal Open Market Committee (FOMC) meeting minutes were released on 28 May 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 the Memorial Day weekend in the US 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 favourable. 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.
Credit sectors pick up the slack
US President Donald 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 US$380bn, which could net the US Treasury more than US$300bn. 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 mortgage-backed securities (MBS) with a focus on near-term valuation and volatility rather than the possibility of privatisation. 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 US$36.1tn and Treasury’s cash on hand stands at roughly US$600bn.
- 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 US$30bn per day, but expenditures are variable and not smooth as portrayed by an average.
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