A November To Remember

Now that we have entered the final month of 2023, we look back on November 2023 with warm feelings and a fixed income performance backdrop that has made all the difference in the world. It was not all that long ago when we saw a 5% 10-year UST yield during intraday trading, and since the beginning of November through month-end, the benchmark yield declined by 40-basis points, while the 2-year yield fell by 22-basis points. Bonds captured a strong and consistent bid last month across the usual suspects, and December is being teed up to double-down on solidly positive returns as a finish to this year. Record performance in November would seem to upend what was otherwise poised for a third consecutive year of Treasury losses. We understand that there is one month left to go, and as we know all too well, anything could happen. However, circumstances that availed themselves last month are likely to reprise their role throughout December and potentially into the opening months of 2024. With the final FOMC curtain set to come down on December 13, contracts pricing currently shows a de minimis probability of a rate hike, leaving the Fed to hold the target range of the Fed funds rate to between 5.25% - 5.5% and effectively pausing the tightening cycle for the third consecutive policy meeting. Rate hike fatigue has joined the policy narrative and while we would not rule out another 25-basis point bump, we believe that fundamental conditions argue in favor of bringing the current tightening campaign to its natural conclusion. 

For 2024, we do not view global recession as a base case, yet we must be careful not to be overly optimistic given the uncertainty of geopolitical events and the potential for diminished consumer engagement. Having said this, it is reasonable to think that our call for a “softish” landing is worthy of making it into our base-case of expectations. We need to pay attention to any growing corporate and/or consumer loan delinquencies, a potential sign of economic softening and perhaps a signal that some of the easy money financing is unwinding. However, one could rationalize a return to more normalized corporate behavioral patterns and households may find themselves better positioned to avoid the most impactful financial stress tied to a diminution in disposable income, rising credit card liabilities with reduced access to credit and eroding savings account balances. Should we see lower capital outlays and a contraction in business fixed investment, prospects for a modestly negative GDP for Q1 2024 likely become elevated. The delicate challenge for the Fed is to effectively message the end of the tightening cycle, while cautioning against telegraphing an easing bias. While any probability of a pivot has now entered the Central Bank conversation, at least formally, in order for the Fed to cut rates sooner rather than later, perhaps we would need to see the emergence of a financial crisis, a meaningful decline in consumer engagement, or some type of geo-political event, any one of which could catalyze negative quarterly GDP. Not only do contracts reveal no remaining rate hikes during the current policy cycle, they now reflect well over a 50% probability of a 25-basis point decrease at the March FOMC with even stronger conviction for a May reduction. Further signals of a slowing economy and stakeholder interpretations of Chair Powell’s comments taken to mean that a pivot is on the table supported bond prices last week. A number of other Fed officials offered their own words of guidance, with strong dovish leanings overall. A quick survey of 2024 FOMC voters suggests no urgency to passing additional rate hikes with incoming data expected to remain key to subsequent decisions.

In November, munis returned 6.35%, besting UST and high-grade corporates, which earned 3.47% and 5.98% respectively. Including the extended positive performance in December so far, the three fixed income cohorts are earning 4.15%, 1.42%, and 4.91% respectively, led by rising market expectations for a Q1 2024 rate cut and supportive data points such as slower CPI and softer job formation. Indications continue to point to a reduced probability of a January 20th partial government shutdown. Portfolio performance yielded strength throughout November for many investors taking on fixed income duration risk with stakeholder conviction that the Fed has completed its tightening campaign and that a pivot to an easing bias is now close at hand. As we know, market stability has been scarce throughout 2023 and we grew particularly concerned over the accelerated back-up in yields of significant proportion during October that had the potential to bring on recessionary pressure. November’s relief rally alleviated much of this pressure, relegating any heavy recession narrative to the back burner, for now. 

Ultra-short UST had visibly underperformed the longer-duration trade in recognition of the higher-for-longer-no-more bias. Like UST, shorter-dated munis underperformed the broader muni index. While General Obligation bonds underperformed the general market, revenue bonds outperformed in November. Investment grade hospital, housing, and education revenue bonds, among other revenue cohorts, outperformed the broader revenue and main muni bond indices, likely attributable to an extended duration strategy for those sectors that have been among the poorest performers. The investment grade hospital sector ended November with the best performance in the IG revenue bond space with a gain of 7.89%, again a previously beaten-up sector. Taxable munis earned 4.95% last month, outperforming UST (3.47%). Muni high-yield outperformed the broader muni index in November, earning 7.75%, with long-duration high-yield posting even stronger returns as tolerance for risk set in for the month. On a high-yield sector basis, tobacco and Puerto Rico significantly outperformed the broader high-yield cohort, making up considerable ground that was lost in the negative returns of October.

A key driver of December muni performance should be technical factors, with new-issue supply expected to be manageable and reinvestment demand at active levels. According to Bloomberg data, approximately $19.2 billion of muni bond calls and maturing securities will be available for reinvestment over the next 30 days, while new issuance over the same period is about $10.7 billion, resulting in net negative supply of about $8.5 billion. While cash allocations into the municipal asset class are appropriate given the yield and income opportunities, we would point out that the end of tax loss harvesting should result in more normalized bid-wanted activity and may result in accretive benefits to fund flows. Having said this, we are in favor of cash allocations into the asset class given the potential for muni out-performance through the balance of December nd into 2024. We believe that forthcoming data will reveal a further slowing of economic conditions with more disinflationary progress taking hold.