4th Quarter 2023 and Annual Fixed Income Review
• With “tactical” changes in the Treasury Department’s quarterly refunding operations, and a “pivot” from the Federal Open Market Committee (FOMC) at their December meeting, although volatile, fixed income sectors experienced positive performance during Q4 leading to gains for the year
• The FOMC hiked its Fed Funds target rate a total of 100 basis points in 2023, ending at a range of 5.25% to 5.50% at the July meeting, but “paused” at the last three meetings of the year
• At the December meeting, Fed officials signaled that they expected three 25 basis point cuts in 2024, but markets are currently pricing-in more
•The core rate of inflation has declined, but is still higher than the Federal Reserve’s stated target of near 2% (the Federal Reserve’s preferred measure of inflation, the core PCE price index, was 3.20% at the end of November)
Select Bloomberg fixed income index returns for Q4 2023 and year-to-date:
During the month of October, the US Treasury (UST) market showed considerable weakness reacting to “hawkish” rhetoric from the mid-September FOMC meeting. Not only had the FOMC signaled it anticipated keeping rates “higher for longer,” but it also quashed expectations for two future Fed Funds rate cuts previously set out in their Statement of Economic Projections (SEP) earlier in the year. The weeks following confirmed their actions with a string of surprisingly robust economic data- a blockbuster payrolls print of +336,000 jobs (over 150,000 more than expected), and an equally bombastic estimate for Q3 GDP of 4.9% were probably the most notable. Yes, the Fed’s preferred measure of inflation (Core PCE Deflator) was trending downward, but not fast enough. Adding “fuel to the fire” markets were also becoming concerned about increased Treasury issuance following a larger than expected 2023 federal budget deficit. The yield on the 10-year U.S. Treasury Note, which began the year at 3.88%, rose almost 50 basis points during October, briefly touching a seventeen year high just over 5%. Paradoxically, the bond market was doing much of the Fed’s work for it- higher yields across the board were creating tighter credit conditions and lessening the need for future monetary policy actions.
Some observers have noted adjustments in the Treasury Department’s quarterly refunding activities in Q4 also had a material impact on the UST yield curve. On the last day of October, the US Treasury’s Quarterly Refunding Statement indicated it was funding the deficit with a much larger amount of very short-term debt- effectively creating “scarcity” in longer-dated Treasuries. According to Dan Clifton, head of policy research at Strategas, Treasury’s decision to fund massive long-term liabilities with very short-term instruments was a “tactical and political masterstroke” for the current Administration- but further commented the wisdom of the measures will be left for “future generations to determine”.
In Fed Chair Jerome Powell’s press conference following the FOMC meeting on the first of November, when queried about the current rate environment, he said on the one hand that the FOMC was proceeding “meeting-by-meeting” in evaluating policy decisions, but he also admitted “we’ve come very far with this rate hiking cycle, very far.” The comments were a notable shift from months of his normally hard-nosed demeanor regarding Fed policy. Almost immediately, a rally began in Treasuries as investors took Powell’s comments as an indication that the Committee was potentially at the peak of the current hiking cycle.
The rally continued through the end of the year, pulling the 10-year UST yield all the way back down to 3.88%, more than 110 basis points over a period of two months. Of note, this is the same level it started in early January twelve months earlier. The two-year UST Treasury Note made a similar move, falling from its October high of 5.22% to 4.25% at the end of the year.
Economic data points such as unemployment moving up to 3.9% in early November, and CPI falling faster than expected in mid-November countered stronger data from the previous months. Market fervor did calm slightly but the mid-December FOMC meeting delivered, without a doubt, the most impactful economic news of the quarter. The mantra of “higher rates for longer” was thrown out of the proverbial window. During Chair Powell’s press conference, he indicated the possibility of rate cuts had been discussed among the members of the FOMC. The “Fed Pivot” was finally upon us, and the peak of the hiking cycle was tacitly acknowledged.
The Fed Funds Futures market veered even further into the land of accommodative monetary policy expectations following the December FOMC meeting, discounting, at one point, that seven 25 basis point rate cuts would take place over the course of 2024. If this were to be the case, rate cuts would potentially occur as soon as March. To date, no FOMC member has given any confirmation for such a timeline, and several have gone on record walking it back. The current yield of the two-year UST Note, a widely followed indicator of overnight rates in twelve months, does support four 25 basis point cuts over the next twelve months.
Q4 was an interesting quarter for non-Treasury sectors of the fixed income markets as well. As was the case for most of the year, more generous cash flows offered from lower credit quality sectors led to outperformance, even in the face of a potentially slowing economic outlook. Likewise, falling interest rates in the US weakened the US Dollar somewhat toward year-end and emerging market debt also outperformed.
Higher quality sectors of the fixed income market, including investment grade corporate bonds, continue to trade fairly “rich” with credit spreads well below historic averages. Similarly, due to seasonal supply constraints and continued investor demand, tax-exempt bonds ended the year at what would be considered historically unattractive levels compared to Treasuries of similar maturities. This observation is currently more pronounced in short-term sectors of the yield curve where the elevated FOMC overnight rate still has a profound impact.
What We Think
For the most part, 2023 did not go as a majority of economists forecast at the beginning of the year- and fixed income markets were extremely volatile. Stronger than expected economic growth in the latter half of the year, and a very resilient labor market, pushed rates to the highest point in over a decade before numerous factors coalesced to precipitate one of the most forceful Treasury rallies in history. It’s clear the consensus economic outlook is for a “soft landing” in the US economy as inflation trends lower and many point to weakening in some sectors of the jobs market allowing for the US central bank to ease overnight rates in the months to come.
Goods inflation was back to zero percent in November and the Personal Consumption Expenditures price index continued to trend lower at 3.2%. Still, job growth has supported the US consumer and resilience in service sector wage inflation continues. Labor represents a much smaller percentage of the US workforce than in the past, but that trend may be reversing. Labor unions have gained more political footing recently than at any time since the Reagan administration and sizeable wage concessions in the automotive and airline industries (among others) may not be isolated. If wage inflation persists it may be harder for the Fed to cut rates as precipitously as currently forecast without an actual recession.
The shape of the US Treasury yield curve changed dramatically over the course of the fourth quarter. As mentioned earlier, there was a significant rise in long-term Treasury yields during the month of October followed by a spectacular rally across the entire curve from the first of November through the end of the year. To say that it was a volatile quarter would be an understatement.
2024 promises to be another challenging year as the markets continue to discount numerous cuts in the FOMC’s overnight rate and questions on the transitory nature of service sector wage inflation persist. Although materially lower than a few months ago- real interest rates (that portion of a bond’s yield above the rate of inflation) are still at higher levels than any time in the last fifteen years. Six trillion dollars in money market funds ($2.3 trillion of that in retail funds according to Yardeni Research) sitting on the sidelines keeps plenty of dry powder available as well. Wars can escalate, it’s a presidential election year, and the next exogenous event not on the radar screen should keep things quite interesting.
We continue to recommend selective exposure to certain higher yielding sectors of the fixed income markets- namely high yield taxable and tax-exempt bonds, emerging market bonds, and higher quality asset-backed securities through the numerous actively managed funds and other strategies that we pre-vet and continuously monitor. Although these portions of the market are historically more susceptible to economic turbulence, we have confidence in our managers and continue to watch for signs of pending economic weakness.
Further, although adjusting portfolio duration to more “neutral” levels in recent quarters, our core fixed income strategies continue to favor high-quality and selective additions as opportunities present themselves. We hope you will contact any member of our fixed income team with questions or observations regarding this commentary or our thoughts on the markets in general.
For additional information, please contact one of the commentary contributors below:
Sam Boldrick: firstname.lastname@example.org
Hutch Bryan: email@example.com
Matthew Kimbrough: firstname.lastname@example.org
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