Higher For Longer Should Not Mean Investment Paralysis

Watching bond yields these days is a lot like looking at a runaway train, yet perhaps that train is carrying some unconventional monetary tightening baggage that could possibly unpack a conclusion to the Fed’s 2023 rate hike campaign. U.S. Treasury yields have spent the month of October attaining new cyclical highs, with the 2-year reaching its highest level since 2006 and the benchmark 10-year actually touching 5% and a bit beyond before staging a retreat. For those market stakeholders following the odds, contracts pricing places a negligible probability on a 25-basis point rate hike at the October 31/November 1 FOMC meeting. We continue to maintain that the Fed has ample flexibility to proceed slowly as it considers prospects for additional tightening. We have reached the point where the effects of a 5.25%-5.5% targeted Fed funds range should have visible consequences for the economic trajectory. Admittedly, such effects were expected to be more pronounced by now, but the overall resiliency of the economy has been a recurring surprise even though we are seeing cracks in the economic veneer. Although the accelerated rise in bond yields originates from outside of our initial base case, we expect the sell-off to reach its conclusion soon. With absolute deference to the stickiness of inflation, we would have preferred that the Fed had ended its 2023 tightening campaign at least one if not two rate hikes ago, as we grew increasingly uneasy over the potential for a policy error. Subsequent economic reports will undoubtedly drive the prospects for any further tightening next year, yet for now we are comfortable with the current target range of the funds rate and would argue that various geopolitical uncertainties contribute to potentially destabilizing forces.

Against a backdrop of solid disinflationary momentum, inflation should continue to come down, but probably not at the pace that most of us would prefer, and this observation can be witnessed on a global stage. While there has been much progress made in terms of controlling goods inflation, more work has to be done in terms of alleviating service sector pricing pressure, which was very much present in the September CPI report.  We further expect overall GDP to trail today’s growth performance at some point beyond the halfway mark of 2024 with evidence of softening consumer engagement, and our forecasts seem to be reflected by more recent Fed Beige Book revelations pointing to softer expansion. For now, consumer engagement is active, with September retail sales rising beyond forecast and providing further evidence of household demand. When we start to see more visible evidence of a hesitant consumer, that is when the growth trajectory will shift closer to our expectations of slower performance. While we assign a low probability of a Fed pivot through much of next year, we would argue that the Central Bank has attained a sufficiently restrictive policy level which very well could receive even greater recognition from team Powell. From our perspective, the higher-for-longer narrative can mean something quite different than a higher-from-here trajectory. Suffice it to say, there has been a notable tightening of financial conditions, particularly given the relaxed probability of a policy shift to lower rates over the foreseeable future. Nevertheless, such tighter financial conditions may be sufficient to bypass further rate hikes this year or even next year. The House of Representatives had just elected Louisiana Representative Mike Johnson as the new Speaker, ending a politically-charged conflict that threatened the ability to pass key legislative agenda items. This includes new spending legislation to avert a government shutdown just ahead of the Thanksgiving recess. The longer the Washington saga played out, the greater the risk of a shutdown, and now the funding debate includes border security, and aid packages for Ukraine as well as for Israel and the Palestinians. The looming November deadline was thought to have been a key catalyst to end the House leadership impasse or else the risk of finger-pointing would have escalated as we enter the general election cycle. 

Intensifying geopolitical conditions have yet to forge a flight-to-quality trade as the entrenched bond market volatility has consumed the directional forces which, for now, could keep the 10-year UST benchmark within the 5% zip code. Having said this, we must wonder if the geopolitical uncertainty creates a natural cap on Treasury yields. As we have alluded, evidence of a resilient economy with all of the growth, employment and consumer participation ingredients has been fostering the higher rate backdrop, with Treasury market technicals and swelling Federal deficits adding to the upward pressure on yields. Foreign buyers have been stepping back, the Fed continues to unwind its balance sheet, Treasury has to refinance outstanding debt at more expensive terms, there are heavy maturities coming due next year, and present buy UST decisions are often guided by the appeal of locking in the next level of higher income streams even against the prospects of further bond losses, and any intermittent rally could enable investors to unwind positions at better price points. Having said this, market stability has been scarce throughout 2023 with stakeholders hanging on every word of Fed-speak in search of the slightest policy clue pointing to the end of the Central Bank’s tightening cycle and to what conditions need to be present for a pivot to an easing bias to occur. That pivot seems to have been pushed deeper into 2024 and we believe that had it not been for this revised expectation, market stability would likely be making more than just a cameo appearance. As 2023 approaches the finish line, we find ourselves thinking about the yield and income opportunities that defined the year. We must also consider the losses posted year-to-date across fixed income cohorts thanks to the enduring bond market sell-off that has also come to define 2023. A widely anticipated recession with an attendant policy shift to an easing bias never materialized, so far preventing a return to positive fixed income returns and teeing up the third consecutive year of losses for UST. Should Treasury market technicals improve and a geopolitically-driven flight-to-quality bid emerge, we could see a meaningful retreat from the currently lofty yields by year-end or early 2024. Most market participants would agree that a 5% UST entry point is compelling following an extended period of nearer-to-zero interest rates and query just how much higher yields can go. 

Bond market behavior has taken over for the Fed since its last FOMC meeting as a steeper curve and term premium are at least worth 25-basis points of tightening. While the yield curve remains inverted, it is important to note that with the recent advance in long-dated yields, such inversion has narrowed with the expectation that the 2s/10s curve will ultimately steepen ahead of the next recession with longer tenor yields converging with, and eventually exceeding those yields on shorter dated maturities. Here, the conventional backdrop would be attendant rate cuts orchestrated by the Fed to bring down short-dated bond yields (aka bull-steepening), yet perhaps we are presently experiencing more of a bear steepener as falling bond prices are being led by longer maturities, reflecting less recessionary prospects and more of the belief that Fed rate cuts are a long way off. In any event, monetary policy and market volatility will likely remain thematic as we begin a new year, yet our hopes call for stabilizing forces to set in and control the narrative at some point next year. Certainly, we have been seeing some rather enticing tax-exempt yields, only to be especially showcased when applying taxable equivalent yield calculations across Federal, state, and local tax exemptions, which can generously exceed 8% for those taxpayers in the top Federal marginal tax bracket.  The yield advantage for munis becomes even sweeter given the vagaries of both market illiquidity and inefficiencies for the asset class. As muni curve inversions abate, ratios are showing better relative value, now available with modest risk exposure given the historically sound credit quality of the asset class.  A 5%-plus tax-free yield at a discount has captured investor attention, extending beyond certain hospitals and higher education credits to better quality and somewhat shorter maturity items as the market continues to soften, and has helped the argument to moderately extend duration to lock in the generationally high cash flows. While Treasuries are looking at their third consecutive year of negative performance, muni returns are being set up for their second consecutive year of losses. Munis entered the month of October from a position of perceived weakness as the current month is generally not kind to tax-exempt performance given weaker technicals. Fund flow behavior has been extremely challenging as consistent withdrawals have added liquidity pressure in the secondary market. Without more supportive technicals and with persistently higher bid-wanted activity, municipals will likely feel the heat as performance continues to disappoint. 

Moving closer to year-end, we do anticipate more active tax-loss harvesting, which will likely extend secondary market challenges. Against this backdrop, had it not been for the coupon carry in support of performance attribution and as an offset to principal erosion, overall muni returns would likely be weaker. An anticipated supply-build over the near-term can be expected to further challenge muni investor sentiment and may contribute to downward pressure on tax-exempt returns. With a number of institutional buyers spending time on the sidelines, such as life insurance companies and certain crossover buyers, we can expect to see cheaper valuations on the long end of the muni curve. We are still holding out hope that fund flows could engage with a positive trajectory, but it would take a great deal of volatility containment for that to occur. Year-to date, fixed-income cohorts are generally posting negative returns. Munis are moderately outperforming UST, but both munis and Treasuries are underperforming corporates. Munis are returning negative 0.74% month-to-date, but are outperforming the October bond market sell-off. While fixed income may very well end the year in the red, munis stand a reasonable chance to outperform UST. The supply deficit is on the rise, but we do not believe that we are looking at a large enough supply deficit that would likely have a dramatically positive impact on muni bond performance. There could be some support, but stability must come about before we see flow conviction.