Rates never sleep

By its nature, bond investing requires patience, and the patience of investors has been tested lately by periods of rapid on/off volatility in bond markets. The third quarter of 2024 provided its share of the same, but ultimately produced the fourth best quarterly result in 34 years as measured by the 5.2% return of the Bloomberg Aggregate Index. Admittedly, we were somewhat surprised by the degree of strength in the quarter, which was fueled at least partially by the Federal Reserve’s aggressive first rate cut of 50 basis points in early September. We believe Federated Hermes’ corresponding strong overall performance results can be attributed to the patience of our active and diversified investment approach, as well as the ability of our Alpha Pod committees to synthesize differences of opinion and be constructively positioned as the US rate cut cycle began. 

Rates rule the roost

While  sector decisions are typical drivers of relative performance within the Core and Core Plus Universe of managers, Federated Hermes’ Q3 returns benefitted more from positioning by our Yield Curve and Duration committees which took advantage of a steady, though choppy, normalization of the yield curve. With rates now back to more traditional levels across developed markets ex Japan, recent rate volatility has been more pronounced, in both curve shape as well as rate direction. The speculation around the extent and pace of Fed easing combined with volatility in jobs and other economic data provided opportunities to profit from corresponding market movements along the way. Consequently, we’ve been actively but carefully adjusting our duration position and booking a year-to-date gain, while also maintaining an aggressive steepener trade that has proved more profitable as the yield curve normalizes.

With rates dominating the discussion, positioning within multi-sector strategies has been more nuanced as we enter the final quarter. Our ongoing overweights to emerging market debt (EMD) and mortgage backed securities (MBS) have proven fruitful year-to-date, demonstrating the importance of low-correlation sectors in the Core Plus universe. Credit spreads were stable to moderately tighter during the third quarter, and all sectors of the bond market outperformed Treasuries. On the spread side, relative to peers, our credit positioning has been more defensive, which was somewhat detractive for us in the first 2 quarters of ’24. But in the markets as a whole, we’ve seen diminishing contributions to excess returns in the historically tight IG and high yield spread markets that we feel validate our current underweights to those sectors, which we get to from a value perspective. 

No shortage of unknowns

Overall, risk assets have had a strong run this year, with narrow corporate spreads and rising portfolio values from stock and bond market appreciation suggesting an environment of favorable financial conditions and stable growth. A surprisingly strong jobs report in the first few days of October reinforces a positive narrative. While perhaps the “easy money” has been made, the yield curve should continue to steepen. We may continue to see some back and forth between a bull and bear steepener. The Fed appears determined to return the federal funds rate to neutral from restrictive territory. If the Fed eases monetary policy while the economy is weakening, the curve likely bull-steepens with short-maturity rates falling faster than long-maturity rates as the market prices more interest rate cuts by the Fed. On the other hand, if the Fed eases while the economy is strengthening, the curve is expected to bear-steepen as rising inflation risks cause long-maturity rates to rise faster than short-maturity rates, creating an increase in the term premium. Thus, when it comes to risk budget, our internal emphasis is on yield curve over duration.

The November US election is  a key variable to consider during Q4. Future economic policy and tax-cut expiration or extension will depend on which party prevails in the House and Senate as well as the presidency. We believe patience is required before taking a strong position on duration as the rate market doesn’t do too well in pricing binary events. We also see potential opportunity in currency, based on election outcomes and dollar shifts. The weakening dollar has benefitted non-dollar holdings year-to-date, but that is also a trend that can shift quickly, so we often tend to be more tactical regarding this factor.