'Tis the Season

Undoubtedly, 2023 will leave an indelible mark upon the investor community as the volatile swings in valuations were reminiscent of the market backdrop of 2022. It was not until the late innings of Q4 when we saw the 2023 fixed income performance resurrect itself and pave the way for positive year-end returns. Throughout November and into the opening days of December, UST yields had steadily marched lower with the 10-year benchmark down by over 100-basis points since October 19. Perhaps 2024 is being teed up to be a good year for bonds with the yield curve showing meaningful steepening and additional opportunities to extend duration. The market tone ahead of the final FOMC meeting of the year was largely positive, without any meaningful consideration given to the slightest possibility of a hawkish message delivered during Chair Powell’s accompanying press conference. The Fed’s decision to leave the target range for its benchmark funds rate unchanged between 5.25% - 5.5% for the third consecutive meeting was fully expected and took account of November’s moderating economic conditions with evidence of slowing growth following strong Q3 performance, and the idea of future rate cuts has now officially entered the policy conversation. Although the Central Bank has not ruled out further tightening moves, indicating that the policy rate is at or near peak levels, the financial markets would suggest otherwise as they see the Fed falling under heightened pressure to cut rates at the May/June FOMC meetings. The December meeting concluded with a revised Summary of Economic Projections (SEP), revealing in our view little if any surprises. Chair Powell readily acknowledges an easing of inflationary pressure, but also argues that inflation remains elevated as the 2% Fed target remains very much front and center to the Central Bank’s narrative. The next SEP will be released at the March 2024 FOMC meeting and if the Fed is truly data-dependent, we must be prepared for additional adjustments to the “dot-plot”. 

Since the September meeting, the number and timing of rate cuts have shifted to a more dovish bias, yet the futures contracts seem to be getting ahead of Central Bank messaging. At the moment, there is approximately 140-basis points of easing priced into 2024, yet we question whether there will be sufficient economic softening to warrant such anticipated rate cuts. Even the most devout naysayers would have to acknowledge that inflation is falling closer in line with the 2% target and that the big, bad recession that was feared to come in 2023 never materialized. Against this backdrop, the Fed needs to get the inflation part of its calculus right, meaning that inflation holds only a very low probability of reigniting. If this outlook plays out, the easing trajectory can take on a preferred slow and steady course rather than an accelerated one that would normally be illustrative of a deep economic contraction. Given the rather dovish interpretations from last week's two-day FOMC meeting, it came as no surprise that Fed-speak quickly dispelled the notion of a Q1 2024 rate cut, suggesting instead that the first easing move would be more of a third quarter event. Between now and the March SEP, Central Bankers will have an ample slate of new economic reports to consider, and we expect further signs of ebbing inflation as well as moderating labor market conditions. While 2023 opened with a substantial amount of work left to do in respect to arresting uncontrolled inflation, 2024 emerges from a much better place. The bond market appears to be comfortable with the idea that the Fed funds rate is at, or at most 25-basis points away from its peak. Whether a pivot occurs in Q1 or in the second half of 2024, we suspect that a new trading range will hold in place until new data entrants tell us otherwise.

From our vantage point, fixed-income allocations in 2024 should be rewarded as the potential for total return performance is quite real given the relative likelihood of less market volatility and reasonable prospects for booking something more than “carry” attribution. Next year is an election year, and we do not expect any new substantive fiscal policies, without-sized spending priorities, to emerge from Washington, D.C. Deficits and higher debt service costs on government debt matter, but they may matter more in 2025, and so we do not anticipate attendant upward pressure on bond yields to be a 2024 phenomenon. Nevertheless, UST returned negative performance in 2021 and 2022, and saw some red in 2023 until green shined through, and we remain bullish on fixed income heading into 2024. Objectively, above-consensus growth and overly stubborn inflation with corresponding higher-for-longer rates could derail our outlook.  Throughout 2023, we had referenced ample amounts of sidelined cash awaiting investment guidance and active deployment. Even after the sharp advances on fixed income asset valuations, we think that 2024 can still offer opportunities for investors to capture performance, tax-efficiency, strong credit quality and diversification through portfolio allocations into municipal securities. As expected, the muni primary market will finish out the year with relatively light issuance which is expected to be greeted with solid demand. Actions and comments surrounding last week’s FOMC meeting have been directionally supportive of muni bond prices and we view this as a harbinger of favorable things to come in early 2024. With muni yields spending much of the year under upward pressure, attractive cash-flows created a strong “carry” component to performance, providing an offset to principal losses as well as defensive portfolio attributes. These cash-flows will likely extend into 2024, although we expect far less price erosion. Sustained favorable technicals throughout much of 2023 were largely accretive to performance and munis can be expected to outperform UST with “net negative supply” potentially extending this outperformance, yet such anticipated outperformance may be challenged given what we expect to be a march towards looser monetary policy with a higher probability of intermittent rallies. Against this backdrop, we remain encouraged by the elevated prospects for fund flows to turn, at the very least, intermittently positive as demand for product accelerates into 2024. We are forecasting a conventional “January Effect” for 2024 with ample reinvestment needs resulting in net negative supply of about $11.4 billion over the next thirty days according to Bloomberg data.