Total Return Outlook: A New Type of Dual Mandate

Thanks to the recent banking crisis, the Fed’s “dual mandate” has taken on a new meaning. The increased economic uncertainty during the first quarter drove investors towards safer assets, boosting investment grade bonds.

A New Type of Dual Mandate

The investment grade fixed income market enjoyed a strong, yet volatile, start to the year. The Bloomberg Aggregate Index (Agg) bounced back nicely following 2022’s unprecedented 13% loss, its worst-ever performance for a full calendar year. The Agg returned 2.96% in the first quarter of 2023, as investors directed meaningful flows to investment grade bonds, partially to participate in their recovery and also to benefit from the potential of a Fed pivot (either ending or perhaps even reversing its restrictive monetary policy).

The Federal Reserve was faced with a new form of a dual mandate in the first quarter, as two bank failures forced it to provide sufficient liquidity to the banking sector while maintaining vigilance in its fight against inflation (as if manufacturing a soft landing was not already difficult enough). A modern-day point-and-click run on Silicon Valley Bank culminated in the second largest bank failure in history when California regulators seized control of the $200 billion bank on March 10th. Two days later, New York regulators took similar action on Signature Bank, which heightened concerns around a systemic banking collapse. The contagion was not limited to U.S. shores, as Credit Suisse was forced into a fire-sale merger with UBS by the Swiss National Bank. Not surprisingly, investors responded to the crack in the confidence of the banking system by seeking safe-haven investments.

The resulting flight-to-quality led to a rally in the two-year note of over 125 basis points (bps), and the fed funds futures markets went from pricing 99 bps of hikes to 89 bps of cuts by December of this year. The primary instrument to measure volatility in the fixed income market, ICE BofA MOVE index, fell just short of hitting 200, which is a level not seen since the depths of the Great Financial Crisis in October 2008. To stem the tide, the Federal Reserve, the FDIC, and the United States Department of Treasury issued a joint statement in support of the banking system and honored the deposits of Silicon Valley Bank and Signature Bank. The Federal Reserve also announced the creation of the Bank Term Funding Program (BTFP), which provides liquidity to other depository institutions to prevent further bank runs. The BTFP allows eligible depository institutions to borrow against their long-dated U.S. Treasuries and agency mortgage-backed securities (MBS) at par, even if the securities are trading at a discount in the open market.