3rd Quarter 2023 Fixed Income Review
• Due to a rising Fed Funds rate and continued “hawkish” rhetoric from members of the Federal Open Market Committee (the FOMC), most fixed income sectors experienced negative performance in the 3rd quarter but are slightly positive year-to-date
• The FOMC hiked its Fed Funds target range 25 basis points in July to 5.25% to 5.50% but “paused” at the most
recent meeting in September
• At the September meeting, Fed officials signaled that one more 25 basis point hike may be needed before yearend to curb demand but surprised markets by reducing the number of rate cuts anticipated in 2024 by half
• The core rate of inflation has declined, but is still much higher than the Federal Reserve’s stated target of near
2% (the Federal Reserve’s preferred measure of inflation was 3.90% at the end of August)
Below are select Bloomberg fixed income index returns for Q3 2023 and year-to-date:
Tough sledding for US Treasuries in the third quarter worked its way across all sectors of fixed income leading to near break-even or even negative returns across the board. Sporting tighter credit spreads in the current environment, longer dated bonds and higher credit quality sectors have underperformed riskier counterparts all year as the US Central Bank has led other global central banks in the fight against inflation. A strong US Dollar continues to be an offshoot from these activities.
Higher for Longer
For the most part, US Federal Open Market Committee (FOMC) activity during Q3 was laid out by forward guidance the market received during Q2. In June, the Fed embarked on a slower pace of hawkish/restrictive monetary policy moves, pausing at that meeting, yet indicating in the June Summary of Economic Projections (SEP) that, on average, FOMC members expected two more rate hikes before the end of 2023.
The July meeting held few surprises with another 25 basis point rate hike, raising Fed Funds to the 5.25%-5.50% range, the highest level since March of 2001. Interestingly, there were no significant changes to the forward-guidance from the meeting in June.
At the World Economic Symposium in Jackson Hole this past August Fed Chair Jerome Powell maintained tough rhetoric and continued his “data dependent” stance regarding future monetary policy activities. In a much-anticipated speech during the Symposium, Powell likened the FOMC’s current task in some ways as “navigating by the stars under cloudy skies,” clearly pointing out the inherent fallibility of economic forecasting.
Almost eight weeks following the previous meeting in July, the September 19-20 FOMC meeting produced another “pause” but the SEP contained significant adjustments to previous Fed guidance, seemingly surprising numerous factions in the marketplace. Similar to the release in June, members of the FOMC indicated a willingness to raise Fed Funds an additional 25 basis points by year-end, if economic data continue to support further restrictions. However, a material reduction in the number of potential rate cuts expected in 2024 was made- where June guidance indicated four potential 25 basis point rate cuts during 2024, September guidance cut that by half (indicating only 50 basis points of rate cuts for the entire year). It was this change which underscored FOMC resolve to tame inflation and a “higher for longer” mantra which pushed longer-dated Treasury yields to levels not seen in over 15 years by the end of the quarter.
Weakness in the US Treasury market continued from Q2 when the yield on the 10-year bond bottomed out near 3.30% following the high-profile failure of Silicon Valley Bank, and others, in March. During Q3 the yield on the 10-year ranged from 3.84% in early July to 4.57% at the end of September. Such a significant surge in the benchmark 10-year yield over the last six months should have far-reaching consequences and many strategists believe it reduces the chance of a “soft landing” in the economy.
Although the UST yield curve remains inverted, with shorter term yields higher than longer term yields, a condition which has historically preceded a recession, the recent sell-off in longer-dated Treasuries has also closed the yield spread between the 2-year UST and 10-year UST markedly. At present, the differential in yields (yield spread) is around 30 basis points where that same yield spread was over 100 basis points as recently as July. The folks at Capital Economics have pointed out that a “dis-inversion” of the 2-year to 10-year Treasury yield curve caused by a steep sell-off of longer dated bonds, or “bear steepener,” is a very rare occurrence, and a recession generally follows (source: Bloomberg).
Our Thoughts
Although trending lower, inflation continues to hover at levels well above the long-term 2% target range espoused by the FOMC. The most recent Personal Consumption Expenditures (PCE) Price Index excluding food and energy, the FOMC’s stated favorite measure of inflation, posted a rate of 3.9% on an annualized basis for August.
The US labor market continues to show resilience with a steady unemployment rate around 3.8%, although wage growth continues to moderate, according to Renaissance Macro Research. As we said in our Q2 comments, service sector employment numbers continue to indicate steady demand while it’s fairly clear that manufacturing is in a recession, mixed signals for sure. Presently, unionized labor appears to be gaining some traction in the US- a development with long-term inflationary implications for any industry effected by this trend.
Leadership is relatively narrow, but the S&P 500 has recovered nicely from the lows of 2022 (while retreating almost 8% from the recent peak in July). A protracted inversion of the US Treasury yield curve points to an impending economic downturn though risk assets continue to outperform higher credit quality in the bond markets. Clearly, compelling arguments can be made for either a relatively severe recession or a “soft landing” in the US economy depending upon where one looks. As mentioned in our previous comments- many of our best economic research sources are at odds with each other.
We continue to believe the FOMC is at or very near its current cycle peak in the Fed Funds rate. Taking them at their words- many FOMC members are on record indicating they may vote to keep overnight rates at or near current levels for a considerable period of time to allow for restrictive measures to work their way through the economy.
The recent rout in longer-dated US Treasuries reflects strong economic data and a heavy supply of new debt being issued while a number of normal buyers of UST debt (think China and likely Japan) are sidelined. A higher rate environment will not only pose a threat to risk assets but may eventually lead to opportunities to selectively purchase longer maturity US Treasuries and other quality fixed income at rates not seen in decades. We have recommended patience while the Fed conducts its fight to quell demand for quite some time, but we are watching for opportunities to moderately extend duration in high quality fixed income sectors such as corporate credits, tax-exempts, and private credit in the months to come. Although sources of significant outperformance in recent years, we continue to monitor our riskier fixed income allocations, such as high yield debt and bank loans, for signs of possible stress.
More “normalized” interest rates resulting from the FOMC campaign to combat inflation over the last twenty months have given fixed income investors the most attractive cash flows available in many years. Money markets and T-Bills paying in excess of 5.00% are hard to resist, but we also recommend opportunistically adding to higher quality fixed income allocations to provide diversification, cash flow, more predictable long-term performance, and a significant volatility offset for riskier allocations in our client portfolios. Some fixed income sectors are beginning to offer “equity like” cash flows. We hope you will consult with your portfolio manager or contact any member of our fixed income team to discuss our thoughts as well as opportunities.
Not Investment Advice or an Offer | This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
For more information about the commentary found in this newsletter, please contact: Sam Boldrick: sboldrick@argenttrust.com or Hutch Bryan: hbryan@argenttrust.com
