Economic Commentary
- The US Gulf coast diesel crack spread cleared $100 per barrel for the first time on record in August against a normal range of $15 to $30. Unlike a gasoline spike, which lands on consumers as a one-time tax on discretionary spending, diesel is an intermediate input embedded in the delivered cost of nearly every physical good, from freight and rail to agriculture and construction. This means that the rise in diesel prices does not stay contained in the energy line of CPI but moves, with a lag, into core goods and services, which is the type of pass-through that the Fed cannot dismiss as transitory.
- Three FOMC participants spoke yesterday, and all three sounded hawkish. Richmond’s Tom Barkin said the inflation picture turned more persistent over the summer, which likely means inflation itself was more persistent than he expected over the summer. Cleveland’s Beth Hammack warned repeated shocks have created an “inflationary mindset,” evident in the speed with which rising input costs pass into core prices. Philadelphia’s Anna Paulson said further rate hikes might be needed.
- Treasury purchased only $4.08 billion of the $6 billion maximum liquidity support buyback.
- The September PMIs were stronger than expected. The manufacturing index rose from 53.9 to 57.0 and the service index from 56.5 to 58.7. The composite index, at 58.4, is highest since the early days of the post-pandemic reopening in 2021. The economy, already growing at a 5.1% rate, according to the Atlanta Fed’s GDPNow, may be stronger still when September data are incorporated. Solid output and demand coincided with the fastest gain in order backlogs since May 2022, wage pressures that have “picked up,” firms “reporting increasing problems finding suitable staff,” and “supply chain delays the most widespread since July 2022.”
- However, the Philly Fed service sector diffusion index tanked to a contractionary -22.0 reading in September, more than twice as bad as the already weak -10.6 August print. The Richmond Fed’s manufacturing index, which swung from +4 in August to a seven-month low of -2 in September, with capex and hiring plans rolled over in a major way here as well.
Our Take
Interest rates have been spiking almost relentlessly lately, on account of strong economic growth, high energy prices, supply shocks, and a Fed rate hike cycle. Fed history suggests yields can tend to peak 2-3 months after the first hike. This time, geopolitics could play a larger role in determining whether that pattern holds. However, the risk/reward of bonds with yields at these higher levels can get more compelling with each tick higher in rates. The Fed appears committed to bringing inflation under control, with even its more dovish members taking a more hawkish tone. It may take a break in the Iran conflict or a highly esteemed market participant to throw a stake in the ground that bonds are the more compelling relative value play versus equities or other asset classes to turn the tide, but it feels like we could be getting closer.
Corporate Bond Market Commentary
- Investment grade bond spreads tightened 3bp to +77bp, and total returns were +0.09%.
- IG supply was $54 billion across 22 issuers. Demand remained firm as book coverage was 4.6x, new issue concessions were 2.5bp, attrition was 19% and deals tightened 31bp from initial talk to final pricing. This week, supply was $41.85 billion, and estimates for next week are only $48.7 billion.
- IG fund flows were -$639 million.
- High yield bond spreads were 3bp wider to +268bp and total returns were -0.30% (BBs -0.30%, Bs -0.29%, CCCs -0.30%).
- HY new issuance was $9 billion with deals from Amsted, Burford, Transdigm, Novolex, Sabre, and Clean Harbors.
- HY fund flows were a large -$2.5 billion, while leveraged loan fund flows were +$701 million.
Our Take
Large HY outflows pushed BB yields to a 17-month high, including the largest 1-day drop in BB bonds since April 2025. Yields on offer of 8%+ on broader high yield, 6.87% on BBs, and 7.95% on single Bs, have created more favorable income opportunities. We have favored Bs over BBs much of the year on their lower interest rate sensitivity in a strong economic environment; the relative value proposition between Bs and BBs looks more balanced, and we are starting to deploy our large war chest of cash into beaten-up BB bonds.
Municipal Bond Market Commentary
- The muni index was down for the 6th week in a row, declining -0.35%.
- Muni yields were +18bp, +6bp, +4bp and +2bp, and muni ratios were +3%, unchanged, unchanged, and +1% to 65%, 66%, 74%, and 91% at 1, 5, 10, and 30 years respectively.
- Net flows into muni ETFs were $3.9 billion, the biggest calendar-week total in the 993-week history of muni ETFs. Overall fund flows were +$736 million, overcoming the outflows from mutual funds.
- Trading volume hit a 75-week high as fixed rate bond trading volume was the heaviest since March 2020.
- Last week’s new issuance was $13 billion, of which $12 billion was tax-exempt. This week approximately $10.6 billion priced, with $1.8 billion deals that were planned but not yet priced and will likely get rolled into next week. Next week’s calendar totals $12.5 billion, of which $12 billion is tax-exempt.
Our Take
Municipal bonds have been on a losing streak, with higher interest rates driving negative performance and moderating fund flows in a seasonally weaker time period. However, the massive inflow into muni ETFs last week coupled with heavy trading volume feels like a capitulation or flush. We may not yet be at the bottom, but these are signs of behavior that we may be getting close, and carefully adding some exposure makes sense.
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