Higher for Longer

Strategy

When we look back on 2022, we cannot overestimate the damage the fixed-income markets inflicted on investors.  Investment grade corporate bonds fell 16%.  Long-term treasuries had a total return of -29%.  High yield bonds fell 11%.  Even very short-term treasuries declined 3%.  It was the worst year for fixed-income investors in roughly 40 years.  Equity markets also declined sharply.  The S&P 500 fell 18% and the technology-heavy NASDAQ saw a decline of 32%.  Diversifying provided few obvious benefits last year.  We expect positive returns in 2023 as the Fed completes their tightening cycle and economic activity softens.

Fixed-income investors face a dilemma. Short-term yields are higher than longer-term yields.  Why would an investor purchase a longer maturity security if they are going to receive a lower yield?  It seems counterintuitive but that is exactly what an investor should do in this scenario.  When short-term yields are higher than longer-term yields, the yield curve is “inverted.”  Inverted yield curves generally precede falling interest rates.  As rates fall, bond prices rise.  Prices for longer maturity bonds rise more than for shorter maturity bonds.  Investors in longer maturity bonds can get a 20% return for the year if rates fall whereas investors in shorter-term bonds will earn only 2% - 4%.  So, there is the dilemma.  Accept less yield today for the opportunity to earn a much higher return in the future.    

Last quarter we discussed the importance of call protection and encouraged investors to begin to extend maturities/durations now and not wait for higher rates.  It generally didn’t matter which fixed-income sector you wanted to purchase, we felt interest rates were at a level that warranted action.  Since that time, we have seen a large decline in longer-term yields.  Intermediate yields are also lower.  Short-term yields (6 -12 months) remain near their peak as they tend to follow expectations for Fed rate hikes very closely.  Despite the fact the Fed is likely to raise short-term rates a bit further, longer-term yields have already begun to fall.

What should fixed-income investors do now?  We remain committed to last quarter’s strategy. Emphasize call protection.  Emphasize longer maturities versus shorter maturities.  Emphasize higher credit quality over lower credit quality because credit spreads are roughly “average” right now and in the face of an economic slowdown, it would seem the directional bias is toward spread widening in the next year.  If you are looking at mortgage-backed securities, look for lower coupons versus higher coupons because the call protection is better with the lower coupons.  Liquidity is also something to keep in mind.  In the corporate bond market look at securities that have $1.0B or more per issue.  They trade much more frequently than smaller issues which provides narrower bid-asked spreads.   

"Reality forced the Fed to tighten last year, and it may force the Fed to ease as soon as this year."

The ideas we presented in these pages look very similar to the ones we discussed last quarter.  Inflation appears to have peaked, and the market seems content to see the Fed take the fed funds rate to 5% later this year.  The drop in inflation across many different measures resulted in lower yields on longer maturity securities. The Consumer Price Index, for example, peaked at 9.1% and is expected to be reported around 6% in January.  Economic data remains slightly positive but some of the employment statistics are beginning to soften, namely nonfarm payrolls and wages. Reality forced the Fed to tighten last year, and it may force the Fed to ease as soon as this year.  The yield on the 2-year maturity Treasury has declined 60 basis points in the past few months.  While we do not expect interest rates will fall sharply anytime soon, we do feel strongly that the ideas presented here made sense last quarter and continue to make sense in the current environment.

Our strategy for bonds at the asset class level is straight-forward and possibly more satisfying than the strategy that is specific to municipals.  As it relates to Treasuries and bonds that trade on a spread to Treasuries basis, we encourage a barbell strategy (some exposure short and some long), with an emphasis on quality, and limited optionality/callability.  Our internal analysis suggests in the second half of a Fed tightening cycle, high-quality and longer duration often outperforms other fixed-income areas.  We believe with strong conviction that the Fed is well over halfway through this tightening cycle.  The reason for the addition of short exposure this time around has to do with the outsized degree of yield curve inversion, in concert with the expectation that the Fed will take short rates roughly 75 basis points to as much as 125 basis points higher.  If we get to the point where 1-year and 2-year Treasuries offer yields of 5% to 6%, that is a lot of return for very little risk.

The strategy for munis incorporates the fact that the muni bond yield curve is generally not inverted, beyond the 2-year area.  Last year in anticipation of short muni yields rising, we sold shorter muni bonds and extended to take advantage of the steepness of the muni yield curve and the historically high yields in the part of the curve beyond 10 years.  Market liquidity and general quirkiness made that effort somewhat successful, but we were able to find acceptable bids on fewer than half the bonds we attempted to sell.  As buyers have returned to the muni market, there may be an opportunity to attempt to sell some of the bonds that did not sell last year, but the yields on the long end of the municipal curve have fallen significantly from the levels we saw in late-October.  To that end, the municipal strategy is somewhat “wait and see.” Wait to see if credit fears take longer muni yields higher, either for those with cash, or wait and see if the muni yield curve shape becomes such that selling some of the remaining short pieces and extending ahead of a recession becomes a possibility.  This year our best hope for a compelling trade opportunity would center on an emerging fear of credit exposure.

Observations and Outlook  

We can be sure of one thing in 2023, the Fed is determined to get the inflation rate much lower than where it is currently.  Their main weapon for accomplishing this task is by raising short term interest rates to the point of possibly causing a recession.  This is one of those exercises that one won’t likely know if they have gone too far until it is too late.  If history is a guide, we will be in a recession by the time the Fed figures out it raised rates too much.  There is a small chance inflation comes down to a level that appeases the Fed without resulting in a recession.  We expect a mild slowdown based on the fact there are not many areas of the economy showing significant excesses like we saw prior to the Great Recession.

Some prominent bond fund managers seem to think the Fed needs to start listening to the bond market.  Specifically, longer-term bond yields have fallen from their high levels experienced in late-October and the yield curve has inverted (a situation where short-term yields are higher than the yields on longer-term bonds).  Curve inversions often precede recessions, but they can give false signals.  In recent history, an inversion of the 3-Month Treasury Bill and the 10-Year Treasury Note has been a good “tell” that a recession is imminent.  Such an inversion may be signaling that the market’s longer-term growth expectations are more subdued relative to where Fed policy is at the time (which the 3-Month bill may pick up better than the commonly referenced 2-year Treasury).  We believe it is saying something that the 112-basis point inversion of the 3-Month Treasury Bill and the 10-Year Treasury note at the time of the writing of this piece, is greater than during the depths of the Great Recession in 2007.  It may be the bond managers who need to hear the Fed.  They have often cited that the problem in the 1970’s and early 1980’s was that the Fed at the time became accommodative too soon, and inflation expectations became “baked” into economic expectations, requiring additional tightening to induce an inflation-breaking recession (referred to as a double-dip recession).  The Fed “apology tour” referenced in last quarter’s Insights piece may not be for posterity, rather it could be because they know what is needed to bring inflation (and the cost of borrowing) down to a sustainable level.  They may hold out hope that people who are living at the margin hear the message and add some reserves or adjust their spending habits, but betting against the U.S. consumer’s propensity to spend is typically a risky proposition.  

"...betting against the U.S. consumer’s propensity to spend is typically a risky proposition." 

The mistake that many market participants may be making is that they think part of the Fed’s job is to deliver a “comfortable ride.” It is reasonable to believe that orderly markets probably offer more stable functionality and growth, but stable may be different than pleasant.  The “Fed put” (the idea that the Fed will step in to sooth the financial markets upon any meaningful turbulence) may have lulled the markets into thinking the Fed’s mandate included financial market pleasure.  Although the Fed has dabbled at expanding their mandate, such as identifying climate change as an economic risk, and expanding the “full employment” mandate to encourage real wage growth in economically disadvantaged communities, they have recently signaled their resolve to “stick to their knitting” and focus on full employment and price stability.  Our interpretation of the recent Fed President and Chairman’s comments is that they are mission-focused, wringing inflation out of the economy. 

Markets expect the Fed will be in a position to cut rates by the end of the year.  According to the CME FedWatch Tool, two-thirds of traders expect that the Fed Funds Rate will be at or below the current rate range (4.25% to 4.50%).  That is greatly conflicting the Fed’s outlook where no contributors to the Fed’s “Dot Plot” indicate any cuts to rates in 2023.  Job growth metrics are strong, and the Current Seasonally Adjusted Unemployment Rate for December was 3.5%.  Against the generally accepted definition of “full employment” being a 5% unemployment rate, there is room for the Fed to tighten further and allow the lagged impact of past tightening actions to be more fully felt in the economy, before easing should be at the tip of the tongue of the market.  As is often the case, markets think you have to go from somewhere to somewhere, with little weight given to the prospect of a pause.  The pause, with modest but proactive adjustments may be the best hope for a soft landing, or even the victory of a shallow recession (provided it achieves the durable price stability goal).  Since central bank policy is thought to have a lag of roughly a year (per Milton Friedman’s estimate), the rate that may matter is the Fed’s policy rate minus the rate of inflation in six months to a year.  As measured by Consumer Price Index (CPI), the Fed has more room to hike but as compared to the Personal Consumption Expenditures (PCE) price gauge, the current dot plot path seems promising.  CPI is thought to measure out-of-pocket costs for consumers, where PCE tries to measure the cost of everything we consume (for example health care costs/consumption, which may not be paid by the consumer, they are often paid for by employers or taxpayers).  As Chairman Powell recently stated, speed is less important than the destination.  That may suggest that a policy pause, and subsequent minor policy adjustments are the expected path (sorry to those who prefer certainty and immediate gratification).  

The earlier-mentioned consumer probably holds our near-term destiny in their hands.  The U.S. is a consumer-driven economy and the reaction to the weight of Fed-induced higher borrowing costs will manifest themselves in changing demand patterns.  Big ticket items that are often financed have seen a dramatic swing in consumption.  The formerly “white hot” used car market has seen a dramatic change. According to the Manheim Used Vehicle Value Index, 2022 saw a decrease in used car values of 14.9%, the largest drop in the 26-year history of the index. Last quarter we touched on the rapid change in the housing market.  In December, homebuilder sentiment fell to the lowest level in more than a decade.  The result of the past increase in single-family home prices, along with greatly increased financing costs has greatly impacted home affordability.  Applications to build in November fell at an annualized rate of 11.2%.  Permits for single family home construction fell 7.1%.  Housing seems to have more downside.  Recent durable goods readings have softened some and consumer sentiment numbers are weak by historic standards (but off the recent bottom).  When the substitutions and abstention of purchases moves to smaller-ticket expenses, the Fed’s work may be mostly done and the “slack” in consumer and labor demand should cool the stubbornly strong employment environment and cause wage growth to slump.  According to a poll by Morning Consult, at the end of the third quarter, the share of sticker shocked shoppers who walked away without making a purchase rose from 8.7% in August to 9.9% in September.  Restaurant sales per customer are struggling to keep up with “food away from home” inflation, suggesting that restaurants are not able to pass along their increased costs to consumers.  It is the substitutions, “trade downs”, and cessation of purchases, for the small stuff that will telegraph that the Fed is making progress in their fight against inflation. According to the New York Fed, through the third quarter of 2022, due to increased credit card balances and mortgage balances, households increased debt at the fastest pace in 15 years.  If real wage growth flatlines, or becomes negative on a real basis, it would appear the consumer will be a critical part of the Fed’s plan.     

"Bailouts may be coming back into vogue, because discipline and responsibility seems to be out of fashion." 

Last quarter we detailed several areas where aspects of the economy could “break.” Although our forecast is that the consumer will falter, followed by the strength of the employment environment, it is areas of the financing and credit markets that could break in a way that causes the Fed to have to step in to rescue orderly markets.  That is not to say the Fed put is alive and well.  Given what must be done to Mainstreet we expect that the central bank will be fine with run-of-the-mill pain on Wall Street.  Heavily financed assets, that have seen a rapidly diminished value of the collateral, is an area we would watch.  This can apply to homes, autos, closed-end bond funds, junk bonds and possibly debtor nations.  According to the New York Times, more than $110 billion of home mortgages have an average down payment of 6.6%, or less, and nearly half of that amount has a down payment equal to or less than 3.5%.  More than $250 billion of mortgages had a down payment of 9.3% or less.  Certainly, many of these mortgages are for properties where some equity has built up, but if residential real estate values fell 10% to 15%, there would be a risk of a lot of underwater homeowners, stuck in their homes.  Subprime auto loan defaults are up 36% year-over-year through October (which places delinquencies still at a historically low level – In the Great Recession delinquencies peaked at 15%, we hit 5.13% in October), and as mentioned earlier the collateral has experienced a dramatic drop in value.  Some closed-end bonds funds that use leverage (they borrow in the short end of the market and use the funds to buy longer-term bonds) have seen their leverage work against them.  As a result, some closed-end funds have slashed their dividend by nearly 50% (wait until the Fed hikes rates 75 basis points more).  The timing of a looming recession may be just what the junk bond market does not need.  Although maturities of junk issues are looking modest in 2023, the calendar of high-yield bonds maturing in 2024 is more substantial (and ideally the companies would arrange new financing well in advance of the maturing debt).  Many junk issuers can’t pay down the debt that they issued when yields were hundreds of basis points lower.  Making matters worse, the spread (the incremental yield a corporate borrower pays over a like-term Treasury to access the capital markets) is currently in the range of 400 basis points to 500 basis points.  In a typical recession, junk bonds spreads more toward 800 basis points over the comparable Treasury.  There is an imminent scenario where the junk bond market becomes problematic, and such an environment can precipitate a situation where investors and even banks pull back on their interest in credit exposure.  Although banks are generally well-capitalized, so we don’t anticipate meaningful bank failures in the next recession, if their appetite to lend is cut off, it can contribute meaningfully to a credit crunch.  Given the debt binge that world governments have been on since the Great Recession, and all the way through the pandemic experience, if credit freezes, large problems may arise.  Since 2007, the G7 nations have seen their public debt as a percent of GDP move from 81% to 128% in 2022.  Italy, who’s debt service costs were 3% of GDP in 2019, is expected to see debt service costs hit 7% of GDP by 2030.  Bailouts may be coming back into vogue, because discipline and responsibility seems to be out of fashion.

"The people that were helped by the stimulus may have been harmed more than any other group." 

Smart people have surmised that it may be possible that sticky wage inflation and other stubborn sources of inflation might mean the Fed would have to accept an inflation rate that exceeds 2%, perhaps something on the order of 3.5%.  Something between 3% and 3.5% would be in line with long-term averages.  As of December, more than 50% of CPI components were seeing annualized rates of inflation in excess of 4%. Our response is that due to the hardwired expectation of nearly free financing, a large percent of the population will “do without” until reality moves in line with their expectations.  If your $2,500 monthly house payment budget used to buy you a $750,000 house and now you would have to settle for a $475,000 shack, you will simply keep renting until the market comes back to you.  At a higher level, it may be easier for low-wage earners to maintain a standard of living if the rate of inflation is low (hopefully, they would have a better chance of experiencing real wage growth).  During this inflationary episode, many workers saw wage gains that looked positive, but that were negative on an inflation-adjusted basis.  We expect that is the primary motivator for the Fed.  The people that were helped by the stimulus may have been harmed more than any other group.  The pain of a recession, which is often felt by those at the bottom of the economic ladder, may eventually benefit them over the long run (and we don’t say that flippantly).  The crux of our basis for why elevated inflation is unlikely, is that in September, following a largely ignored policy meeting, the Fed revised down significantly the US potential output.  Of note, the Fed’s assumptions change due to disappointing productivity gains and slow improvement in labor force participation.  We have mentioned the Output Gap in the past (the theoretical maximum output for an economy).  Typically, the economy runs below the maximum output (a negative gap).  Occasionally, the economy can run above the theoretical maximum output (a positive output gap), but typically this only happens for short periods of time and it almost always portends a recession.  It may be the case that running the economy hot causes malinvestment or production costs for goods and services that are unprofitable.  Do you pay a pizza delivery person $50/hr., or do you offer customers $3 per pizza as a discount to deliver it to themselves (turn a fixed cost into a variable cost)?  The next revolution in productivity may come from the customers themselves, paying at the individual level for sources of utility that are specific to them, along with capital investments in automation and applications for artificial intelligence. From a Fed policy perspective, the reduction in the potential output means the economy was running even more overheated over the past two years than previously thought.  For context, at the end of 2022 the positive output gap on a real basis was 0.66% and prior to the Great Recession it peaked out in 2006 at 1.13%.  The average output gap for the past 20 years was roughly -2%.  It might suggest that some output gap shrinkage is required to lower inflation expectations and stabilize the economy.  Short rates will rise farther, and longer-term bond yields have farther to fall as an economic slowdown, and all the new uncertainties that go with that, become the reality. 

The Fed must deflate the recent inflationary episode.  They have recently sharpened their messaging to say what they have to do may be unpopular and that their focus is once again on their dual mandate of full employment and price stability.  The main consternation of the market will likely be the fear of the unknown.  Chairman Powell has said the speed of this journey is not a goal he expects, and speed may actually produce a result that is counter to their real goal, but the destination (full employment and average inflation of 2%) is the prize.  That journey means millions of unfilled jobs will vanish, millions of people may lose their current job, and GDP will probably shrink in the near future.  It will not be a comfortable ride, but rather it may be a trip that is required to achieve more lasting future comfort for many people.  We expect the Fed will use the word “pause” in their post-meeting statements this year (and they may throw in a “data dependent” for good measure).  So now we wait and see.   

 

 

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