Rates March Higher
Strategy
In October of 2023 we wrote that a recession is coming. This was based on a number of very reliable recession indicators. It was also based on the fact that the most aggressive Fed tightening cycle ever would not end with a soft landing. There were six rate cuts priced into the market and inflation was headed lower. Interest rates peaked in October of 2023 and declined steadily until year end. GDP forecast showed a mild recession in 2nd and 3rd quarters of 2024. It seemed like the path of least resistance.
As the economic data for the 1st quarter was released, we saw inflation move higher, interest rates move higher, and the odds of six rate cuts drop to three. In addition, the 3rd quarter GDP increased 4.9% and many expected a sharp decline in the coming quarters. The 4th quarter, reported in early 2024, increased 3.4%, which was stronger than expected. It appeared the only sector negatively impacted by higher interest rates was housing. Higher mortgage rates resulted in very anemic existing home sales. While this may be the first time the Fed engineers a soft landing after raising rates, the odds don’t favor that outcome.
The middle portion of the yield curve (2-year through 10-year Treasuries) increased 35 basis points in the first quarter. In April the same maturities increased an additional 20 basis points. Clearly, stronger-than-expected economic data has caught investors off-guard. Given this back-up in rates with the expectation of lower rates later this year, it seems like a great opportunity to invest in bonds now. Many newly issued CMOs trade at a slight discount to par and provide yields close to 5.50%. This is a 100-basis point yield spread. Extension risk is low because prepayment speeds are very low. These investments are subject to a spike in prepayments should mortgage rates fall over 1.0%. The yield will be maintained but the average life declines to 1.5 years from the original 4.5 years.
Another option is to buy a deeply discounted 20-year mortgage-backed security (MBS). Let’s look at an MBS issued 3 years ago. It has a 3.0% coupon, sells for $89, has a 6.0-year average life and a 5.13% yield. If rates fall and prepayment speeds increase, the bond’s yield will rise because prepayments come in at $100 but the purchase cost was $89. Modeling shows if prepayment speeds double, the average life shortens from 6.4 years to 4.8 years. These MBS are government-backed and have no credit risk.
"The sector of the corporate bond market with very generous yield spreads is financials."
While we generally like corporate bonds for their high yield and excellent liquidity, the yield spreads are currently narrow on a historical basis. The sector of the corporate bond market with very generous yield spreads is financials. An example would be a large bank issuer that is rated A1/BBB+. The bond matures 1/24/2029. It trades at a yield spread of 80 basis points over the 5-year maturity Treasury yield. The Treasury has a 4.40% yield making the financial institution bond yield 5.20%. This is an attractive yield for a “too-big-to-fail” bank bond. The issue size is $2.5B which makes it very liquid. The 5-year maturity Treasury traded at 3.80% last fall, so we believe this is a great time to invest given it now offers a yield of 4.40%.
We have been very consistent in our view that investors should move to the longer end of their duration range. Honestly, it’s been disappointing watching rates rise this year. There has been no economic slowdown, and inflation has been moving the wrong direction. Having said that, we are maintaining our preference for longer duration securities. It’s taken longer than we thought but with even higher rates as of late it makes good sense. One gets bombarded with new information in this industry daily and it’s easy to follow the trend. We reject that notion and are sticking with our call to extend the duration if possible and appropriate.
Interest Rate Outlook – With All This Positivity, What Could Possibly Go Wrong (Plenty)
We will start with the “positives” in the economy. As mentioned earlier, the manufacturing sector finally joined the service sector in experiencing expansion. At the start of the quarter, real wage growth showed the largest gain since July of 2023, after many months of nearly flat real wage growth. By some measures, the household sector is less leveraged than was the case in 2008 (during the Great Financial Crisis). Since mid-2008 total household debt has grown by 36% while incomes have grown by 85% over the same period. Household debt as a percent of disposable income is currently near the lowest levels experienced over the past 40 years if you exclude the pandemic years. Now that interest costs are elevated and saving rates are at low levels, it is reasonable for this metric to deteriorate soon. Non-mortgage debt, including auto loans, student loans, and other revolving forms of credit have seen significant growth over the past decade. The interest expense on these personal lines of credit as a percent of disposable income have spiked to levels experienced just prior to the 2001 and 2008 recessions, so the most expensive and volatile sources of credit may be weighing on the consumer. Finally, the job environment continues to demonstrate surprising resiliency. In March, the unemployment rate ticked lower to 3.8%, down from 3.9% in February. People who want to work can find a job and perhaps that is enough to keep the consumer feeling good for much of 2024.
Against the backdrop of expansion in the service and manufacturing sectors and plentiful jobs, signs of inflation persist. January experienced an unexpected jump in Core CPI and the “Supercore” Services Index. Elevated CPI readings have been constant through the quarter. A key subset of CPI, services prices, increased by the largest amount in two years. The main contributors to the updraft in inflation were food, car insurance, medical care, and shelter costs, which contributed to more than two-thirds of the overall increase. The combination of economic growth, persistent inflation, and a robust job environment makes the evolving and nimble Fed position appropriate.
With so many things going well, what could go wrong? The geopolitical issues that have been in place continue to present massive risks to global growth. On a more peaceful note, simple central policy dispersion between the world’s central banks could cause market consternation. As Europe is expected to slip into a recession in the coming months, the ECB is expected to start cutting rates. If one of the United States’ largest trading partners is facing recession, it may create an economic drag. China is facing depressed levels of growth and a real estate crisis, along with the friendshoring trend, which may act as a weight on global growth. Friendshoring could also result in exporting inflation around the globe as trade moves away from partners with the maximum comparative advantage. In last quarter’s Insights piece, we identified slow global growth and exogenous shocks as frequent reasons given for the impetus for past Fed easing cycles. It seems like central bank policy dispersion, divergent economic growth, supply chain reshuffling, and geopolitical tinder offer many sources of economic challenge.
Looking closer to home, we have concerns about the consumer and the seemingly unstoppable job environment. Below the surface of the ISM Manufacturing and ISM Non-Manufacturing releases, which we referenced earlier, rests data that could shake the unflappable job market. For both the service and the manufacturing sectors, the “employment” component of both metrics has been in contraction for the past couple of months (longer for the manufacturing sector). The number of available jobs, the JOLTs index, is mostly in a declining trend and the ratio of job openings to unemployed people eased to a four-month low of 1.36X. The “quit rate” which measures voluntary job departures relative to the share of total employment recently remained at 2.2%, the lowest level since 2020. It indicates that US workers are less confident about their ability to find other jobs.
"At a time when the labor market is robust, the uptick in delinquencies is worrisome."
A very different take on the state of consumer debt as compared to the interpretation referenced in the previous page is that US consumers are outspending their income, and it suggests the economy is not as strong as one would think. A real possibility is that more borrowers observe the ways in which debt can turn into free money. Student loan debt is an obvious example where some non-needy people can have debt amassed for the purpose of future wage advantages expunged. Student loan debt has increased by 60%, or $600 billion, since 2013. Some people have identified the resumption of payments on student debt as a “threat to consumer spending.” One person’s threat is another’s version of personal responsibility. The combination of the ISM employment numbers, with accumulated debt, declining savings, and rising delinquency rates should cause concern. Over the past four years, personal spending growth has annualized at 6.7% while the average annualized growth in personal income has been 5.9%. Over the past 25 years, both personal income and personal spending have averaged a more balanced 4.6% rate of annual growth. Consumers have accumulated record levels of credit card debt and due to the rise in interest rates that started in 2022, interest payments on credit card debt have nearly doubled in two years. Levels of delinquency on auto loans and credit cards have risen toward levels not seen since 2010. Specifically, transition rates of new credit card balances and auto loans that are 90+ days late are at 6.4% and 2.7%, respectively. During the peak of the Great Financial Crisis, the numbers were almost 11% and 3.5%, respectively. At a time when the labor market is robust, the uptick in delinquencies is worrisome. The U.S. savings rate has fallen to 2.9%, nearing the lowest levels in 15 years. People may be expecting the government to step in to avoid the threat of reduced consumer spending that their lack of savings, accumulated debt, and outspending their earnings growth could precipitate.
Individuals aren’t the only ones that are positioning themselves for future challenges. The recent rise in rates, our insatiable appetite for deficit spending, and general lack of discipline will very likely make the cost of servicing our federal debt a part of the national conversation leading up to the election. One outcome seems certain, none of the viable candidates will balance the budget and put the country on a sustainable and fair path. The social contract between the generations appears to be in jeopardy. In previous quarters we dug deep into the consequences that frontier countries are facing because of their inescapable debt burden, along with the here and now costs of servicing the U.S. federal debt. The world is awash in debt and in a fractured global paradigm, a substantial debt burden may become a competitive disadvantage (unless you believe the following approach to debt has staying power: borrow so much that your banker doesn’t sleep at night, and you do). We continue to expect the themes of the election will be stimulus or austerity, or more probably stimulus or stimulus.
"We continue to expect that rates will be higher for longer, and the more likely scenario is that activity slows toward the end of the year."
Whether it is individuals, governments, the housing market, corporations, or commercial real estate, borrowing costs have consequences. The belief that a restrictive Fed and the highest rates we have had in nearly 15 years can result in a soft landing, or no landing, seems like a fantastically remote possibility. What seems more probable is that unimaginable levels of stimulus were pumped through the economy, some of it continues to slosh around today, and that the lag in the delivery of the funds, along with debt payment suspension and forgiveness has allowed the U.S. to pull off the illusion of an economic miracle. High yield debt, leveraged loans, private debt, stocks, and commercial real estate feel like they could have room to reprice in an economic downturn. The magnitude of the commercial real estate market price adjustment, especially for office space, could be disruptive to major institutional investors and financial institutions. Recently the owners of the Chicago Board of Trade building handed the keys back to the bank. The Canada Pension Plan Investment Board just sold its interest in a pair of Vancouver towers, a business park in Southern California and a redevelopment project in Manhattan at discounted prices, with the New York property value at $1. The real estate issue is starting to look like a problem that time won’t heal. We continue to expect that rates will be higher for longer, and the more likely scenario is that activity slows toward the end of the year. The “out of left field” risks as we look out onto the horizon include an exogenous shock or a wave election. The shock scenario will expose the cracks of economic weakness under the surface of the U.S and the wave election offers near-term euphoria, continued deficits, and higher long-term borrowing costs. The coming year represents a difficult period in which to offer an interest rate outlook. If we ignore external influences, we expect that rates will stabilize near the elevated levels experienced at the start of the 2nd quarter and that another regime switch will happen as consumer metrics soften, driving yields lower and possibly prompting symbolic action by the Fed.
The recent updraft in bond yields offers another chance to average into the market, for anything that trades on a spread-to-Treasury basis. A barbell strategy seems prudent with some exposure in shorter bonds and an allocation in the five-year to ten-year area. It allows the investor to enjoy the highest short-term yields we’ve experienced in roughly 15 years, without taking on much risk, while “locking” in the relatively high rates on the longer segment of the portfolio. We expect the yield curve will steepen by short rates declining as the Fed eventually cuts rates as part of an accommodative policy shift. As the curve steepens in this fashion, although the yields on the short part of the portfolio will diminish, subdued economic expectations may drive longer-term yields lower (and prices higher).
Looking at upcoming core CPI data, we may be set for base effect comparisons in the months of June, July, and August, which could present readings that will appear as if the Fed’s actions are not able to get inflation under control. If that occurs before the consumer or the job environment takes a turn for the worse, it may offer a unique buying environment for bond investors. This year will increasingly be polluted by politics, but the surprises leading up to the eventual outcome will drive fleeting market sentiment and future regime switches. As indicated earlier, we continue to encourage a quality bias in portfolios as spread movements could erode returns in 2024 or 2025. It is worth repeating this quarter that exogenous shocks or a wave election represents the most likely “known unknown” that would significantly change our bias and market assumptions.
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