Higher for Longer? Bonds Deserve a Fresh Look
Posted on January 4, 2024
As we entered 2023, the consensus view of market participants and top of mind for many investors, was the widely anticipated U.S. recession. Given the unprecedented scale and pace of the Federal Reserve’s (“the Fed”) rate increases that began in March 2022 — from the near-zero levels that had persisted since COVID — very few saw a runway for a “soft landing”.
It is worth noting that in any given year, the independent probability of the U.S. entering a recession is 15%, roughly one out of seven. Most forecasters were placing recession odds at nearly 50/50, so in essence, over 3x the baseline risk.
What ensued over the first three quarters of 2023 was surprising resiliency in economic data. Job growth has continued apace, averaging 235,000 per month through August (after revisions), although tempering somewhat in the past few releases. The unemployment rate has ticked up only very modestly, largely due to increases in the participation rate, a welcome development given historically tight labor markets. Other measures, notably consumer spending and GDP, have defied expectations and remain at expansionary levels, robustly so for the third quarter. Headline inflation has certainly come off the boil after peaking at 9.1% in June 2022, to now within sight of the Fed’s stated 2% target (3.7% in September). But it is those final few percent that may prove to be “sticky” without some combination of higher rates and a significant deceleration in growth, if not an outright recession.
Indeed, it is the resiliency of the economic data and related persistency of inflation that has required the Fed to go well past the level most believed would be its “terminal rate” (the level at which the Fed ends this cycle). While the terminal Fed Funds rate may soon be upon us (futures markets suggest one more possible raise) it is highly uncertain how long it will need to remain there. As the lone lever of scale that Chairman Powell can pull to suppress aggregate demand, it is not one he is likely to release until 2% or nearly 2% inflation returns — something he has forcefully repeated several times in recent remarks.
Another structural factor arguing for “higher for longer” interest rates may be the fiscal outlook in Washington. The deficit is currently running at 6.5% of GDP and the debt ceiling agreement in June did not meaningfully alter this trajectory, prompting Fitch’s downgrade of the U.S. credit rating to AA+ in August. This elevated level of spending, unusually high for an expansion and in direct conflict with the Fed’s tightening efforts, is also a key reason the “long and variable lags” of monetary policy are proving to be ever longer and more variable. Of interest to bondholders, large structural fiscal deficits generally result in higher nominal (and real) interest rates, all else equal.
Related, a potential government shutdown this fall over these spending levels may provide some headline risk to both equity and bond markets — although history suggests that bonds may in fact benefit from the “flight to safety” that typically ensues for Treasuries and investment grade credit.
Against this backdrop, we believe many clients would be well-served to take a fresh look at their fixed income allocations. Yields on these securities are hovering at 16-year highs and unlike floating-rate cash, bond yields are fixed through to maturity, which insulates you should rates recede. Further, the relative valuation between equities and bonds has rapidly narrowed in favor of bonds, as suggested by the “Fed model” (first used by former Fed Chair Alan Greenspan), which compares the earnings yield of the S&P 500 to the 10-year Treasury yield.
Beyond the improved return outlook, a healthy bond allocation is the ballast in a well-diversified portfolio for weathering investment and economic cycles. The spread of outcomes and volatility of returns are meaningfully diminished over all time horizons, and especially through all historical crises we have analyzed by holding as little as 10-20% in bonds. So, consider going “higher for longer” in your fixed income weightings. Our investment management team is available to review your portfolio and discuss the most appropriate allocation for you. Contact Us.
Kristian R. Jhamb, CFA
Senior Portfolio Manager
LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.
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