MARKET OVERVIEW
The third quarter was marked by a rapid repricing of the U.S. Treasury (UST) curve, resulting in negative total returns across nearly all segments of the fixed income market. Sticky inflation, volatile energy prices, elevated corporate bond issuance, and ongoing concerns surrounding the U.S. fiscal outlook all contributed to the move. However, the primary catalyst was a hawkish shift in monetary policy and the anticipation of additional rate hikes from the Fed. The economy remained largely resilient throughout the quarter, supported by solid consumer spending, continued labor market strength, and ongoing business investment, particularly in AI-related infrastructure projects. That underlying economic strength, while positive from a growth perspective, reinforced concerns that inflationary pressures could remain above the Federal Reserve’s target for longer than previously anticipated. After remaining on hold since 2025, the Federal Reserve, now led by Chair Warsh, raised its benchmark rate to a range of 3.75% to 4.00% in an effort to combat persistently elevated inflation. While refraining from providing explicit forward guidance, his repeated emphasis on price stability, including the observation that “inflation is too high and has been for too long,” signaled a strong commitment to restoring inflation back to target. At the same time, 12 of 18 FOMC participants indicated that at least one additional rate hike could be warranted before year-end 2026. The UST curve experienced a bear flattening during the quarter, with the largest moves occurring in the intermediate part of the curve. Three-year and five-year UST yields rose 86 and 85 basis points, respectively. Longer-dated maturities also sold off, though to a lesser extent, with the 10-year and 30-year UST yields increasing by 82 and 68 basis points, respectively. Following the September FOMC meeting, futures markets repriced meaningfully, ultimately reflecting expectations for one additional rate hike in December and two rate cuts during 2027 as investors weighed the tension between resilient economic growth and the eventual effects of tighter monetary policy.
POSITIONING CHANGES
During the third quarter, spread sector allocations remained largely unchanged, with the notable exception of agency RMBS, where we increased targets by 5% to take advantage of the recent volatility. Purchases were focused on the belly of the curve in 3.5%-5% coupons that are now fully extended and trading at a deep discount. We favor this part of the coupon stack due to the more stable payment profile and now positive convexity profile. We sourced liquidity for these additional purchases from a combination of UST and short-duration ABS, which has served as an excellent store of value amidst the volatility. We modestly increased our CMBS allocation by 2%, ending the quarter at 11%. We were active in buying several new issue SASB deals where the collateral was a mix of industrial, datacenter, and self-storage. In all cases, we participated in the top of the capital structure in well enhanced deals at smaller position sizes which reflects our preference for diversification and liquidity in this market environment. Agency CMBS spreads widened in sympathy with agency mortgages, particularly in September, creating an opportunity to incrementally add exposure. Outside of these larger sector shifts, we continued to opportunistically trim specific corporate names that were purchased at new issue earlier in the year and now trade through fair value. At quarter end, the allocation to credit remains unchanged versus the prior quarter at 23%, representing an underweight position relative to the Bloomberg Aggregate Index. Looking ahead, should spread weakness continue, we would expect to reduce liquidity balances and take advantage of the resulting investment opportunities. More specifically, we are closely monitoring the conduit CMBS market, where defeasance levels act as a buffer in a higher rate environment. Additionally, the new issue ABS market is becoming increasingly attractive, and should spreads continue to leak wider, we would increase target allocations, with a preference for consumer facing, programmatic issuers in the equipment, credit card, and auto segments. While specific pockets of corporate credit have shown weakness, the overall market continues to trade near historically tight levels, reflecting strong corporate earnings and a solid fundamental backdrop. Given a combination of valuation concerns, M&A risk, and potential contagion from hyperscaler weakness, we expect to remain underweight credit unless relative value dynamics shift meaningfully.
OUTLOOK
U.S. growth remains resilient, supported by solid consumer spending and strong business investment. Recent employment data point to a cooling labor market, with September payroll growth falling short of expectations, downward revisions to prior months’ job gains, and a modest uptick in unemployment suggesting a gradual easing in labor demand. Persistently higher energy prices are likely to pressure energy sensitive sectors, while also keeping financial conditions tighter for longer. Overall, the outlook is for moderate U.S. growth, with upside from sustained business investment balanced against downside risks from persistent inflation and elevated borrowing costs. The Fed’s September rate hike validated a more hawkish policy posture, reflecting persistent inflation and resilient labor market conditions. The policy path beyond September remains uncertain, with Fed funds futures markets currently pricing in three additional rate hikes by next June. Persistent services inflation and resilient growth could support additional tightening, while the absence of a wage-price spiral and the restraint already being delivered by higher market rates argue for a measured, data-dependent approach. Reduced forward guidance and internal committee divisions should keep uncertainty around the pace and extent of further tightening elevated, contributing to continued rate volatility. UST markets have experienced a pronounced bear flattening as investors price a more restrictive Fed path. Front-end yields have risen sharply, with the 2-year UST approaching recent highs, while the 10-year UST moved well above 5%. The Treasury’s attempts at stabilizing long-term yields through buybacks have not had their intended consequence and rates are expected to remain elevated as inflation, strong economic activity, and large fiscal deficits continue to pressure the term structure. Yield curve dynamics are expected to remain highly sensitive to inflation data and evolving Fed expectations. While pockets of value do exist, most investment grade spread sectors screen overvalued to us despite solid corporate credit fundamentals and a resilient consumer. Given the recent widening in spreads amid heightened rate volatility and as the 10-year UST yield approached 5%, we are looking to increase our allocation to Agency MBS while remaining mindful of extension and negative convexity risks. Supply is running well below historical norms as elevated mortgage rates suppress refinancing and new origination activity. Extension risk and rate volatility remain the primary headwinds, but absent meaningful labor market deterioration or further geopolitical escalation, the sector should continue to offer attractive carry relative to Treasuries.
