You Can't Keep a Good Bond Yield Down

No sooner does one FOMC meeting pass, than another one pops up on the radar screen. The highlight of September’s gathering was not the fact that Central Bankers chose to pause, but the notion that any expectation of a policy shift towards an easing bias has been pushed deeper into 2024. One main takeaway from the FOMC was the somewhat surprising hawkish rate revisions, yet bond market psychology would suggest a much wider disconnect between what policymakers had been telegraphing ahead of the “blackout” period and the post-meeting messaging. It would seem that the hawks are tightening their grip against a “higher-for-longer” narrative dovetailing with a surprisingly resilient economy, underscored by a strong labor market. Although Fed funds futures are presently signaling a less-than-compelling wager for a 25-basis point rate hike in November, team Powell has left the door open for more restrictive levels. Twelve out of the 19 participants support one additional 25-basis point rate hike by year-end, in line with the June Summary of Economic Projections (SEP). The Fed’s rate posture could very well be challenged by a number of growth, political, and consumer variables. The target range for the Fed funds rate remains at 5.25% - 5.5%, and while the data will likely guide monetary policy throughout the coming months, our preference would be to hold course at least through year-end. House Speaker Kevin McCarthy managed to deliver a 45-day reprieve that, for now, averts a government shutdown, yet that page was quickly turned when his gavel was taken from him after a vote across the House chamber stripped him of his speaker title. While we make a concerted effort to avoid much of the political trappings, which admittedly becomes more challenging as we make our way into a general election cycle, the “House of Cards” dysfunctionality in Washington, D.C. only adds to market anxiety. These events could elevate prospects for a government shutdown, with Moody’s already sounding the ratings alarm.

Suffice it to say, political uncertainty will likely envelop much of the narrative during 2024, and there will be other issues that will expose market, financial and overall economic vulnerabilities, such as the effects of student loan payments coming back on line, protracted worker strikes that are now ensnaring a greater number of auto industry facilities, advancing levels of credit card utilization, eroding consumer savings, prohibitively high mortgage rates (highest in over 20 years) which are eliminating a base far beyond the marginal buyer, and an uncertain economic climate for China. As mentioned, the next FOMC is approaching with the two-day session scheduled for October 31/November 1, and the financial markets are wondering whether the Fed will hand out a trick or a treat upon its conclusion. This meeting will not be accompanied by a SEP, leaving stakeholders to rely on September’s outlook as they thoroughly assess nuance and nomenclature. We have certainly witnessed enough to know that there is a big distinction to be made between “restrictive” and “sufficiently restrictive”. Admittedly, the Fed has charted a restrictive course, but the surrounding debate is having difficulty in reconciling the arrival of sufficiently restrictive, due in part, we believe, to a lack of consensus on the definition of sufficiently restrictive. We neither hold negative growth on our radar screen over the near-term nor do we envision a pivot to a lower funds rate through much of next year. We are simply saying that there are hairline cracks in various pockets of the economy and we believe that in order for the Fed’s 2% inflation target to be met, there needs to be more visible softening in labor market conditions, not the least of which would be a somewhat higher unemployment rate.

As we think about the “higher for longer” mantra, the “longer” part of the calculus can quickly fade, and while a pivot to an easing bias is not on the horizon, perhaps the idea will not vanish completely. When we revised our economic outlook from a short and shallow recession to a soft-ish landing scenario, we stipulated that a policy mis-step and/or a material shift in the economic narrative could move us to revert to our original thesis, and this caveat seems even more relevant today. If the Fed’s inflation outlook turns out to be too high, then a downward adjustment to its funds rate target would be in order. While GDP has demonstrated above-trend performance, we question whether such expansion patterns are sustainable given the potential confluence of headwinds. The consumer has been exceptionally resilient, but we are witnessing a degree of hesitation, and while we do not envision any meaningful dislocation over the medium term, growth expectations will likely be the first casualty should consumer engagement takes an unexpected detour. Despite active consumer participation, we have recently received evidence of eroding consumer confidence which has declined to a four-month low, and the weakest pace of consumer spending in about a year as reported in Q2 data. Businesses are also under pressure given the higher rate backdrop with growing concern over future prospects for investment and capital deployment.

For the first time in about 15 years, bond investors can obtain positive real yields, while capturing a defensive response to inflationary pressure. Furthermore, investors can now be appropriately compensated for crafting diversified portfolios with a number of asset classes providing competitive cash flows, and bonds are presently offering something more than ballast as an offset to volatile risk assets. The monetary policy hawks have seemingly hijacked the bond markets with soaring yield levels attaining new cyclical heights as the extended sell-off leaves a greater impact on longer duration securities. We have been seeing active Treasury supply coming to market since August while the Fed’s quantitative tightening sequence has reduced its balance sheet by about $1 trillion with mounting concern over finding the buyer of last resort as there is too much paper chasing too few investors. The bond market is now doing much of the heavy lifting during the late-cycle tightening campaign, with the result potentially slowing economic activity and re-establishing the recession narrative. Should growth turn negative and the need to rely upon monetary stimulus becomes apparent, such events could catalyze a monetary policy course correction towards an easing pivot sooner than what is presently anticipated. There is currently a narrowing (between the 2s/10s yield gap) in the Treasury yield curve inversion, now with stronger prospects for a flattening trend that could trigger a positive sloping bias. With the ongoing sell-off and a bear-steepening curve testing new technical levels, the bond market may well be oversold, yet we cannot rule out new cyclical highs on yields as supply is likely to stay active for a while and sidelined investors remain weary of the themes expressed in this commentary.

Portfolio performance has been unexpectedly weak for many investors taking on fixed income duration risk with expectations that the Fed was approaching the completion of its tightening sequence and that recession was very much on the table. Ultra-short UST has visibly outperformed the longer duration trade in recognition of the higher-for-longer bias. Across fixed-income cohorts, September performance was decidedly negative, with Munis underperforming both Treasuries and corporates. Throughout September, munis lost 2.93%, and like UST, shorter dated munis outperformed the broader index. Some bear-steepening has also occurred along the short muni curve. Whether we have reached duration capitulation remains to be seen. Having said this, we believe that we are closely approaching the end of the current sell-off, although Friday's strong non-farm payrolls print for September will be making this a bumpy approach. Based upon a historical lack of generally supportive muni technicals for the month of October with a relatively thin net negative supply backdrop, our performance outlook for this month would ordinarily be rather somber. However, should issuers stay on the sidelines amid the varied rate headwinds, such lower supply scenario could turn out to be a small gift for October Muni returns, with munis possibly outperforming a further sell-off. We continue to expect the carry attribution to help alleviate the potential losses caused by any further principal erosion. With the looming FOMC and the rising probability of divergent economic data points throughout the month, rates could remain under upward pressure for a bit longer.