Finding Long-Term Fair Value in Short-Term Rates

William Ahmuty, Head of the SPDR Fixed Income Group, recently interviewed Senior Portfolio Manager James Palmieri on the current risks and opportunities in shorter-duration fixed income. Mr. Palmieri is the head of structured credit and co-portfolio manager of US Ultra-Short-Term, Short-Term, and Core Fixed Income Strategies at State Street Global Advisors.

How would you describe bond markets, especially in the short end of the curve, during the first nine months of the year? Any surprises?

Let’s start with the surprises.

In March, against the backdrop of tight monetary policy, we saw a few regional bank failures. In response, 2-year Treasury notes went from a yield of 5.07% to 3.98% in just a few trading days and credit spreads sharply widened.

The bigger surprise was how little these regional bank failures impacted the broader economy. Job creation and Fed rate hikes continued in the second and third quarters. This led to a recovery in the market to levels not seen since the first week of March. For example, the 2-year Treasury note is back just above 5% and credit spreads tightened significantly.

Overall, what we're seeing is a marketplace where, through our long-term fair value lens, rates are at the cheap side of long-term fair value and credit spreads are pricing tight, or on the rich side of long term fair value. I've described this divergence in pricing between rates and credit spreads as a rubber band being stretched thin. And typically this divergence is unsustainable.

In short, I think the market is no longer really pricing in a hard landing, which makes it vulnerable.

What are the biggest risks and opportunities from now to the end of the year and heading into 2024?

When we think about the direction of travel for the economy, with respect to lower growth and lower inflation against the backdrop of restrictive monetary policy, the primary risk to the market from a pricing perspective is clearly a hard landing. And the market that would be most exposed to that would be the credit sector.

I look at March of this year as a great example of what would happen if we had a growth scare. We'd expect to see rates at current levels rally sharply and likely see credit spreads widen sharply in response.

In terms of opportunity, given our outlook and given the risks in the market, the primary opportunity is in the form of rates — in particular on the short end and, to a lesser extent, the middle part of the Treasury curve.

In terms of spreads, there's really only one market that has pockets of it pricing in an economic hard landing, and that's the CMBS market. And with commercial real estate consistently in the headlines, it's no surprise that there's some softness in that market.

And as we go into 2024, we’re preparing a “shopping list” should pricing in the CMBS market overshoot further to the cheap side of long-term value.

What about funding the US government’s fiscal deficit? Does that raise concerns about Treasury issuance?

I don’t think it's going to be a surprise to anyone that in 2024 we're going to see more Treasury issuance than we saw in 2023. And with respect to T-bills or the proportion of issuance in T-bills, we expect it to remain at the high end of what's called the optimal Treasury debt structure, which is 15 to 20%.

In fact, it’s anticipated that the issuance of T-Bills may slightly exceed 20%. You know, when we think about that much issuance, it helps to have a framework or an outlook.

When I look at the market, it's pricing in what I would call higher for longer.

In that environment, we feel like there'll be plenty of demand for money market funds, which will generate plenty of demand for T-bills. Given some of the challenges with bank balance sheets, they're unlikely to be able to compete with money market rates anytime soon. So, it's possible that this increase in issuance and T-bills could get absorbed if the markets are right about higher for longer.

How are you positioning ULST given your views?

Given our outlook for lower growth and lower inflation against a backdrop of restrictive monetary policy and relative value, cheapness in rates versus credit, I would describe our positioning as favoring duration, quality, and liquidity.

And that translates into a higher allocation to duration, a higher allocation to governments, and a lower allocation to credit at this stage. This leaves the fund well positioned for opportunities to deploy its liquidity at more favorable spread levels should credit reprice over the coming quarter and into 2024.

I think it's important to note that, as compared to last year, short-end-of-the-space-products like Ultra Short Term Bond ETF (ULST), as well as Bloomberg 1-3 Month T-Bill ETF (BIL) and Bloomberg 3-12 Month T-Bill ETF (BILS), are sitting on a lot more income cushion to weather the storm. So, I think that all the rate hikes over the past 18 months have generated an income cushion that is quite compelling as compared to the last couple of years.

What are the risks in allocating to the very short end of the curve?

Well, I think much of the risk that existed for the short duration space has come to pass. Usually what disrupts that market is a surprise inflation print, followed by aggressive Fed tightening — and we've already gone through that storm, so to speak, in the short duration space.

I think most market participants would say that the Fed is very near done, if not already done, raising rates and it's all about how long they'll hold rates.

So, I think the risk to the short end has been mitigated by this Fed moving very fast from accommodative to restrictive monetary policy. I think within this short duration space, you aren't getting paid a lot to take on credit risk. So, that's the primary risk against this restrictive Fed backdrop. And it's why we're holding a lower-than-strategic allocation to credit at this juncture.

Get more insight into today’s higher-for-longer environment in our Q4 Bond Compass.