Market expectations have finally converged with the Fed’s rate guidance, and rate volatility is expected to trend lower this year — creating a constructive backdrop for agency mortgage-backed securities.
US equities swung between losses and gains last week. Recent positive economic momentum supported the soft landing narrative, but upside surprises in inflation and payrolls led to more hawkish Federal Reserve (Fed) rhetoric. These hawkish Fed comments lifted short-term yields, while higher inflation expectations raised 10-year yields.
Annual core Consumer Price Index (CPI) inflation continues to cool but at a slower pace, up 5.6% from a year ago and slightly down from 5.7% in December.1 And as inflation has cooled, retail sales exceeded consensus estimates and rebounded sharply in January.2 Strength in the labor markets supported consumer spending across almost every retail category. Given the jump in retail sales, US personal spending may surprise to the upside. Meanwhile investors will likely keep a close watch on core Personal Consumption Expenditures (PCE) inflation to gauge inflation trends.
The Federal Open Markets Committee (FOMC) January meeting minutes released this week offered insight into the Fed officials’ debate over the pace of rate hikes needed to curtail inflation.
After a series of upside surprises in economic data, from the latest nonfarm payrolls to Consumer and Producer Price Inflation data, the implied federal funds rate for 2023 has finally fallen in line with the Fed’s median projection from December, pricing in almost no rate cut this year.3
Rate volatility is expected to trend lower this year, as we are now close to peak rates and market expectations have converged with the Fed’s guidance. This creates a constructive backdrop for agency mortgage-backed securities (MBS).
For investors who are both concerned about recessionary risks and looking for high quality credit exposures, agency MBS valuations are more attractive than investment-grade (IG) corporate bonds. MBS spread levels are 24% above their median levels since the Global Financial Crisis, compared to 10% below for IG corporates.4
Persistent high inflation and high interest rates have created headwinds for corporate profit margins and strained company balance sheets. The probability of a US recession in the next 12 months has jumped to 57%, based on the New York Fed yield curve model.5 However, IG bonds’ tight credit spreads are not reflecting the negative credit outlook and recessionary risk. Decade-high yields and wide spreads on mortgage-backed securities have created an attractive entry point for investors.
MBS Show More Attractive Valuations Relative to IG Corporates
With a net expense ratio of just 4 basis points — one of the lowest in the US-listed MBS-focused ETF space — the SPDR® Portfolio Mortgage Backed Bond ETF (SPMB) seeks to provide exposure to the multi-trillion-dollar MBS market in a cost-efficient way.6 And it has traded at a penny-wide spread every day for the past year amid elevated bond market volatility.7
SPMB Standard Performance as of December 31, 2022
1 US Bureau of Labor Statistics, as of February 14, 2023.
2 FactSet, as of February 16, 2023.
3 Bloomberg Finance L.P., as of February 16, 2023.
4 FactSet, as of February 16, 2023. MBS is represented by the Bloomberg US MBS Index. IG Corporate bonds are represented by the Bloomberg US Investment Grade Corporate Bond Index.
5 The Federal Reserve Bank of New York, as of January 31, 2023.
6 Bloomberg Finance L.P., as of February 16, 2023. SPMB net expense ratio is 0.04%. Gross expense ratio is 0.05%. SSGA Funds Management, Inc. (the “Adviser”) has contractually agreed to waive a portion of its management fee and/or reimburse expenses in an amount equal to any acquired fund fees and expenses (excluding holdings in acquired funds for cash management purposes, if any) until October 31, 2023. This waiver and/or reimbursement does not provide for the recoupment by the Adviser of any amounts waived or reimbursed. The Adviser may continue the waiver and/or reimbursement from year to year, but there is no guarantee that the Adviser will do so and the waiver and/or reimbursement may be cancelled or modified at any time after October 31, 2023. This waiver and/or reimbursement may not be terminated prior to October 31, 2023 except with the approval of the Fund’s Board of Trustees.
7 Bloomberg Finance L.P., as of February 16, 2023.
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