Volatility Ends Up Being Your Friend
Since the bond market covered a lot of ground in the 4th quarter of 2023, we will offer a recap. At the start of the quarter the resumption of conflict in the Middle East offered a new source of uncertainty to the domestic political challenges in the areas of leadership and the on-again-off-again debt ceiling crisis, and seemingly nearing consequences of deficit spending and growing Federal debt was top of mind for the market. Generally, domestic economic releases at the start of the quarter were strong and the Fed had a bias toward another rate hike to keep inflation in check.
Some “feel-good” developments over the quarter included falling oil prices, which made holiday shoppers feel good at the pump, and unemployment unexpectedly ticked slightly lower to a rate of 3.7%. Signs of moderating inflation, along with a robust employment environment, made a soft-landing a near certainty in the mind of the market. Accordingly, the market priced in roughly six rate cuts, totaling 150 basis points over the next year. The Fed’s own guidance through the Dot Plot suggests three rate cuts in 2024, starting as soon as March. Increased expectations for Fed rate cuts resulted in very strong returns (yields fell) for most areas of the bond market in November and December. The bond market sentiment which started the quarter very negative, with talk of run-away deficits and debt, ended as positive as it was volatile.
The shift in sentiment caused year end returns to go from being meaningfully negative to significantly strong. Our call for returns that were a bit better than current coupon level returns at the start of the year turned out to be shockingly prescient, or perhaps just fortunate. Job market strength met with diminished sources of inflation and the culmination of the impact of one of the Fed’s most aggressive restrictive policies seems to be resulting in a transition to a near-term deflation of the inflation bubble. Currently the market thinks we will have a soft landing, or perhaps no landing as forecasts for a recession have diminished greatly. 10-Year Treasury yields started the fourth quarter at 4.57% and ended up at 3.88%. 10-Year AAA-quality municipal bond yields began the quarter at 3.44% and ended at 2.26%. Through the end of the fourth quarter, the most broadly watched taxable bond indexes experienced appreciation for the year of between 5.2% and 5.5%, while many municipal indexes experienced gains for the year of 4.3% to 5.8%.
Observations and Outlook – The 7th Inning Stretch of “Higher for Longer”
Baseball is the only major sport in the U.S. where spectators are encouraged to stretch in order to tolerate sitting for the rest of the game (sorry baseball fans and sports team clients). Thankfully most trips to the ballpark involve other American pastimes of eating stadium food and having adult refreshments. We expect that the rest of this Fed cycle will feel as anxiety inducing as watching a baseball game without the food, beverages or the 7th inning stretch. Some might say that the typical length of our quarterly strategy piece can be equally taxing.
Talk of a “Powell put” and suggestions that Fed rate policy could be accomplished by following moves in the 2-year Treasury yield support a belief of a Fed that reacts to the financial markets.
Our theme for 2023 was “higher for longer” and our forecast for Fed policy in 2024 is that the most uncomfortable innings of “higher for longer” will morph into the late 2024 and early 2025 theme of “oops, I did I again.” Specifically, elevated real yields will be the biproduct of subsiding inflation data and expectations with continued restrictive Fed policy. The restrictive policy will be in the form of both sustained Quantitative Tightening (QT) as well as through keeping the Fed Funds Rate near the current level which is at a 22-year high. The market and many of its vocal participants seem to believe the Fed follows the market’s lead. Talk of a “Powell put” and suggestions that Fed rate policy could be accomplished by following moves in the 2-year Treasury yield support a belief of a Fed that reacts to the financial markets. Although the market sends pricing and sentiment signals to the Fed, the inputs to policy are likely far more complex. The reason we believe that real rates are a key barometer for the Fed’s next steps is that Fed officials are keenly aware that in 1976 when the Fed cut rates at a time when the real Fed Funds Rate was negative, it helped to spark the second wave of inflation, requiring a crippling recession to quash. Real yields remain around 2% and as mentioned last quarter, the average going back to 1959 is closer to 3%. Although we may be lulled into expecting the 1% real yields, we have experienced for much of the past 15 years, the level of interest rates needed to fund massive deficits and debt may more closely mirror our long-term experience as opposed to the cheap financing costs enjoyed during the zero-interest rate policy era. Since the recent banking system challenges, it appears the Fed is adhering to the Separation Principal, where rate policy is used to alter financial conditions and the Fed’s balance sheet will be used to support financial stability. As the Fed attempts to normalize their balance sheet through QT, an exercise that should take roughly two more years, it seems that there will be pressure on nominal rates as cashflows and maturities from the Fed’s portfolio are not reinvested, requiring the free market to step in its place. In total, it suggests a longer-term propensity toward higher rates on both a real and nominal basis.
Earlier, we mentioned that we thought the market was going to be incorrect about the timing and amount of Fed cuts in 2024, we also think the market is looking at the reason for Fed action from a vantage point that suffers from recency bias, where recent events heavily influence a near-term outlook. We think the market has the “why” part of near-term Fed moves wrong. The Fed hasn’t had to really fight inflation since roughly 1991. Since then, it has managed growth pessimism or euphoria, along with the occasional financial system crisis. Before 1990 when inflation-fighting was paramount, Fed easing generally occurred after the official start of a recession. After 1990, Fed rate cuts often occurred before the official start of a recession (three out of five times – two of the easing cycles occurred without a subsequent recession, earning Alan Greenspan the moniker “The Maestro”). Interestingly, Bloomberg has a machine learning Fedspeak model that measures the tone of more than 50,000 Fed news stories and as of early December, the tone of Fed hawkishness had declined to the level experienced in late 2018, just before Powell’s dovish pivot in January of 2019 when he abandoned plans for further rate hikes in that cycle. Bloomberg also offered analysis of the Fed transcripts from 1990 through 2019 which may offer a longer-term perspective on what has prompted the Fed to act in the past. In descending order of frequency as a cause for Fed action over that period the reasons include global growth, tight credit conditions, business investment and output, consumer spending/confidence, and business inventories. Although the service side of the economy has grown over time, it is interesting how the psyche and health of the consumer was near the bottom of the list and global growth, business health, and orderly credit environments were the most frequent reasons for action. It seems like there are many reasons why the current state of the world and market conditions could make the near future rhyme with the past.
Against that backdrop, the job market pillar of the economy could crumble.
In recent editions of Insights, we have discussed some of the same influences that the Bloomberg analysis mentioned above cited for past Fed actions. Global tensions, tighter bank lending standards, euphoric low spreads on lower quality corporate debt, diminished savings balances for individuals, and the consequences of increasing levels of debt as benchmarked against the size of the economy are all areas of concern. We had been pointing to the strength of the employment environment as a pillar of the economy that would determine whether a soft landing or a recession would follow. The Minneapolis Fed recently released an analysis that suggests that technology has changed the relationship between job openings and unemployment. In short, the ease of posting jobs may lead to a relative overstatement of the number of open positions as compared to historical experience. Available jobs are likely more in line with the number of job seekers. Inside the recent job numbers, away from leisure and hospitality jobs, an overwhelming percent of the jobs gained have been in the areas of local government, state government, and health services & social assistance. If we are heading toward a recession, the recent gains may be in sectors which offer very stable jobs, and recently several states and public entities gave workers raises of between seven percent and nine percent. In some areas public entity jobs are particularly attractive as compared to the private sector. At the San Fransisco Federal Home Loan Bank, average compensation and benefit expense per employee is $310,000 per year, which is on par with Goldman Sachs. At a higher level, some signs of cracks in the employment pillar are emerging. The Quits Rate has been in the 2.3% range, down from the peak of 3% in April of 2022. The ratio of unemployed people to available positions has fallen to 1.3X, the lowest level since mid-2021, and dramatically lower than the peak of 2.0X we saw in 2022. Worker Adjustment and Retraining Notices (WARN notices), which tend to lead layoffs by 60 to 90 days suggests that layoffs will pick up in 2024. Although the services sector of the U.S. economy has been soft since the middle of 2022, the more significant services part of the economy (as measured by the ISM Non-Manufacturing Index) is unexpectedly nearing contraction. In December the index took a significant dive to a reading of 50.6, remember a number below 50 suggests contraction. As it relates to the job environment, a subset of the ISM Non-Manufacturing Index, the Services Employment Index fell more than seven percentage points to a value of 43.3, the lowest reading since July 2020. The manufacturing sector has been slow, if we lose the strength of the service sector, it seems the sentiment of the market will rapidly move from a near certain soft landing, to some degree of recession. Against that backdrop, the job market pillar of the economy could crumble. We look for the erosion to start in the first quarter and the negative feedback loop of economic pessimism translating into dampened business expectations, leading to job losses, have the greatest chance of coming to a crescendo late in the year.
Going back to the most frequent (post-1990) reasons for Fed action, global growth concerns and credit market issues were at the top of the list. As we look at global growth and risks to global growth, the headwinds are significant. In early January, the World Bank stated that the global economy is on track for the “worst half decade of growth in 30 years” and is expected to slow for the third year in a row, dropping to 2.4% in 2024 (down from 2.6% last year). To change course, they said “developing economies need to implement comprehensive policy packages to improve fiscal and monetary frameworks, expand cross-border trade and financial flows, improve the investment climate, and strengthen the quality of financial institutions.” Between China’s real estate and related financial institution challenges along with the profligate deficits and mounting debt in the U.S, it would seem the World Bank believes the world’s largest economies need to manage their imbalances. Depending on how the numerous sources of geo-political tensions play out, that may not be realistic in the context of the times in which we find ourselves. Taiwan’s January 13th elections, in the context of U.S. leadership in a state of flux as the year progresses, offers risks that could throw the world into turmoil. President Xi has recently said that reunification will occur. China has a demographic time-bomb facing them and as the U.S. is distracted by several conflicts, along with diminished will to fund significant portions of the military disputes, we seem to be at a tenuous time of opportunity for China and their reunification wishes. An invasion of Taiwan is expected to shave 10% off of global GDP. A more palatable blockade of Taiwan may reduce global GDP by 5% which is roughly the same amount of GDP shrinkage as caused by the Great Financial Crisis, or the Covid pandemic. The disruption to the global supply chain, particularly semiconductor chips, would completely disrupt manufacturing. Although domestic GDP would plummet and deficits would become massive, it is a dispute the U.S. would be forced to face with partners and allies. Recent events in the world should offer clarity that a lack of fighting shouldn’t be mistaken for progress toward peace. The mere increase in the threat of another conflict in the world seems to have solidified that deglobalization is hardwired into the base case for longer-term global economic activity. It should result in inflationary pressure and act as a drag on the global standard of living, a reversal of the influence China offered on global growth in the 1990s and 2000s, where growth was strong, and inflation was subdued.
As the Fed continues QT it will result in reserves leaving the banking system.
Ignoring the impact that some version of WWIII may have (hopefully, exaggerating for effect) on Fed policy, a more likely dampener on the economy has to do with liquidity, access to credit, and perhaps spreads on lower-rated corporate bonds. As the Fed continues QT it will result in reserves leaving the banking system. Complicating matters a bit is the Fed’s Reverse Repurchase Agreement Facility (RRP) which has attracted up to $1.5 trillion in money market mutual fund (MMF) assets as temporary Treasury bill issuance declined during the debt ceiling crisis and the recent experience where yields offered by the RRP exceeded those provided by Treasury Bills. Short Treasury bills eventually saw increased issuance and the yields rose above those offered by the RRP, triggering roughly $1 trillion in MMF assets leaving the RRP since the peak in 2023. As MMF balances in the RRP move toward zero, the continuation of the Fed’s QT policy will drain bank reserves from the system. If the pace of QT continues for approximately two years, bank reserves may approach ten percent of GDP, nearing a point where the excess bank reserves converge toward zero. Bank loan officers are currently more conservative than they have been for most of the past 15 years, once there is a constraint on bank reserves, credit (the lubricant for the economy) may freeze. A recession may cause this credit contraction to serve as a start to a broader contagion that will spread to broader measures of credit, such as the access to capital and the cost of issuing debt in the corporate bond market.
Although a restrictive Fed and softening economic developments should result in lower yields, a normalization of the shape of the yield curve and the expected future U.S. deficits, mounting debt burden, underfunded entitlement programs, and increased cost to finance the debt should create a long-term upward pressure on interest rates. Last quarter we offered an excruciating examination of the term premium and the natural level of interest rates (r*) needed to fund the debt, especially in the context of a QT world. This quarter we will simply offer the idea that the trajectory of our fiscal situation will have consequences. Taking the medicine now will be far better than the amputations that will be required in the future. Looking at the debt-related struggles of some the world’s frontier countries may offer a window into the future. That is not to say the experience in the U.S. will be of the same magnitude, or as imminent as the world’s poorest countries, but studying the extreme states of any situation is often useful. The debt of the 42 countries classified as frontier countries reached $3.5 trillion in 2023, double of what it was a decade ago. To stay solvent, many of these countries are having to dramatically cut budgets, as debt payments consume their budgets. According to the United Nations, about half the world’s population is living in countries that spend more on debt service payments than they do on education and health care. Citizens of some of these countries are growing impatient with the austerity needed to keep up with their interest payments, which has resulted in political upheaval. As the situation becomes more dire, credit being extended to these nations is drying up. Unlike the U.S. (currently), they can’t ease their burden through printing money and inflating their way out of the problem. To offer a couple examples of what too much debt looks like, Nigeria’s 2022 debt payments totaling roughly $7.5 billion exceeded its total revenue by $900 million and Pakistan spends eight times as much on its interest payments as it does on health care where the government can’t afford ambulances. The solution that is forced upon these countries is some form of reduced spending, raising tax revenue, or default. All the potential ways to address our domestic fiscal problems involve consequences but the challenge is that the near termism of our political structure is a mismatch for the long-term nature of the mounting problems we face. The U.S. should heed the World Bank’s advice and get our fiscal house in order, while the scope of our solutions involves band-aids rather than the loss of limbs.
As mentioned last quarter, nearly every historically reliable predictive recession indicator is flashing red. Manufacturing has been slow, and the service side of the economy is nearing a neutral state. If we lose the support of the service economy, it should only be a matter of time before the volatile and fragile consumer sentiment will turn negative and a downward cascade of the job market will lead to a deteriorating feedback loop. Sticky sources of inflation continue to persist. In the past we have agreed with the idea that the last mile of the inflation fight will be slow and difficult for the Fed to achieve. We would like to revisit that position as our observation that markets tend to move in a regime switching way. It suggests that once the market is given enough negative data, the herd will change from the mindset that the Fed will be able to cut rates by 150 basis points in 2024 (to move toward a historically neutral nominal Fed Funds Rate) to a new view that “this tone deaf Fed is still so restrictive that they need to cut rates by at least 150 basis points, or more, to keep us from a deep recession.” Being a presidential election year, the Fed has a difficult job if it wants to implement surgical easing, balanced with their primary goal of tamping-down inflation expectations, while also not appearing to influence the results of the election. We think the path for rates is that the Fed will make its first cut late in the second quarter. They will be data dependent and we expect that will largely be driven by the state of the job market, evidence that growth is weakening, and the level of real rates. Late in 2024 we think an increased expectation of a recession will develop as growth subsides and rates will fall, with a good likelihood that the yield curve resumes a normal upward sloping shape and the reduction in yields focused on the short part of the yield curve where short rates will fall more than long maturity Treasuries. A divided government should result in a mild but longer than expected recession, followed by a slower progression to the fiscal challenges addressed earlier. A scenario that would put that forecast at risk would be if a surprise candidate emerges that causes a “wave” election and single party rule, it would increase the chances of more fiscal spending, which would make a recession shorter and shallower and the probability of the more dire future solutions to our fiscal imbalance increases dramatically. Since history often rhymes, as can presidential candidates, the election may harken back to the choices of the Great Financial Crisis, stimulus, or austerity.
Municipal Market Developments – Still, Nothing to See Here
Last quarter we felt we were running out of clock for our forecast of coupon-like or slightly better returns for the year. We expected that the returns we anticipated would be pushed into 2024. To our surprise and delight, the bond market experienced phenomenal performance in the last two months of the year, after a very rough October. It is nice to see clients get a break from the anxiety that was caused by the bond market performance for much of the past couple of years. In the end the municipal bond market had returns for the year that were generally between 4% and 6%, somewhat better than current coupon-like returns. As compared to like-maturity Treasuries, municipal bonds are near a historic low for short and intermediate-term bonds. Yields are a bit better than half of the yield of a comparable Treasury whereas the average relationship during the pandemic was roughly 65% and during the 20 years before the pandemic that ratio was almost 100%. The only way the low ratios make sense is if the market is pricing in the expiration of the Trump tax cuts in 2025, along with additional tax hikes. We may have pulled some of the 2024 returns into 2023, so we expect the relative value state of much of the municipal bond market will result in muni returns being lower than what the Treasury market will see in 2024. Our strategy, which involved hanging on to low-coupon bonds, the segment of the municipal bond market that experienced some of the worst losses in 2022, saw dramatic recoveries as the year ended. If sentiment drags yields materially lower later in the year, we will look to swap out of lower coupon bonds to partially insulate portfolios from our longer-term bond market view (that nominal and real rates will be higher than we have enjoyed for much of the past 15 years). In short, we would like to use continued appreciation as an opportunity to partially de-risk portfolios.
It gets old criticizing Chicago’s pension woes or California’s budget choices, but one would think that at a point, if you are in a hole, you eventually stop digging.
ACG analyzes and updates hundreds of municipal and corporate credits annually. Although it is part of doing the job correctly, it offers perspective on the directional health of market sectors and individual issuers. Broadly, well-run municipal entities are healthier than poorly run entities that continue to deteriorate. You may reasonably ask, “why is ACG holding poorly run municipalities?” and the answer is that often institutions and some individuals come to us with existing holdings and rather than sell bonds we would never have bought, which has a bid/ask spread cost to it, we evaluate the credit relative to the holding period horizon of the bond. We sell some of the weak issues, and ride out those for which we have a good degree of confidence that the bond will be fine up to maturity. It gets old criticizing Chicago’s pension woes or California’s budget choices, but one would think that at a point, if you are in a hole, you eventually stop digging. Overall, the problem areas for the market continue to be nursing homes/continuing care facilities, accounting for nearly a third of recent default and distress activity, along with entertainment-related credits, charter schools, private higher education issuers and generally any non-essential projects tend to account for a disproportionate amount of the problems in the muni market on a historical basis. Some pockets of the public-school credits are seeing challenging enrollment trends and the sunset of the pandemic stimulus funds. Even with the challenges of a potential recession, we anticipate that from a credit loss perspective, municipal bonds will largely continue to be the sleepy backwater you should come to expect.
Strategy and Summary
The game is tied up. It’s the top of the 9th inning and you have not so much as shifted your weight in your seat, let alone stood up and stretched. That is what we think 2024 will feel like. Be prepared to be uncomfortable. Global growth is expected to be slow while geopolitical tinder is widespread. The Fed will allow real yields to increase. The market will become more vocal about the Fed’s inaction. Meanwhile they will be slowly achieving their goal of ending inflation. A recession may ensue and that may simply be the cost of the pandemic response excess. Normalized deficits approaching $2 trillion will have consequences. Our best guess is that the electorate will choose higher taxes for a segment of the population. It may be appropriate, but the cost may be diminished future economic growth. On a longer-term basis, structural deficits, and the cost to finance the debt may result in a higher neutral rate, higher real rates, and higher nominal rates than we have experienced for many years. The hard choices that the frontier countries must make now have a direct relationship to the choices we will be faced with in the future. The right answer for most people may be a blend of stimulus/support with a significant dose of austerity. The November elections may be a choice of the brand of medicine we want as compared to the cure we need, or it could be the sideshow we have come to accept/expect.
Owning long duration bonds has historically been a good strategy at the end of a Fed tightening cycle. Short term yields are somewhat average from a long-term vantage point, but are attractive as compared to much of the last 15 years. We continue to like a barbell strategy with some short exposure and some longer exposure, depending on the specific mandate of a particular portfolio. The yield on shorter bonds is likely to decline, but for very little risk you are currently earning a nice return. Risk spreads are tight by historical standards and depending on the depth of a recession they offer potential headwinds to returns in some corners of the bond market. We would urge a quality bias in portfolios as spread movements could erode returns in 2024 or 2025. If the recession is mild and short, spreads could be essentially static. Our strategy specific to municipal portfolios is to let the economic slowdown continue and de-risk to accommodate our longer-term rate forecast. The metrics to watch this year will be the pace of the erosion of the job market and real rates. A wave election represents the most likely “known unknown” that would significantly change our bias and market assumptions.
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