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As the economic data for the 3rd quarter became public, we saw inflation move lower, interest rates move lower, and the odds of multiple rate cuts increase. The Consumer Price Index (CPI) increased 2.5% for August.  The Personal Consumption Expenditure (PCE) rose 2.7% and the PCE deflator increased 2.2%. The Fed has managed to bring inflation toward their target of 2.0%.  The other half of the Fed’s dual mandate is full employment.  The jobs market is softening.  Nonfarm payrolls averaged 270,000 a month in the 1^st quarter but the most recent three- month average is 115,000.  The unemployment rate has increased from 3.7% to 4.1% over the past six months.  The number of job openings fell from 12 million to 8 million.  The Fed became much more focused on the labor market as inflation fell and nonfarm payrolls softened.  It’s also the reason the Fed cut rates 50 basis points last month.  As of early October, the market is pricing in two additional cuts in 2024 and another 3 or 4 in 2025. 

As we head into the end of the year, the economy is on a solid footing, inflation is falling, and the equity market is expensive (when measured on a price-to-earnings basis).  The Fed has embarked on an easing cycle.  The elephant in the room is the ongoing budget deficits.  Federal debt is running at nearly 130% of GDP.  We spend as much on interest expense as we do on defense.  The U.S. is running a $2 Trillion deficit in a year with solid economic growth.  At some point very soon, the bond market will be at odds with the politicians.  Investors will require a higher yield for the risk they are assuming.  Yields will have to rise.  We hope this happens before the debt is so large that there is no way to manage the situation. 

After swimming against the current for the past couple of years in a rising interest rate environment, it’s nice to be in an easing cycle.  We have been actively extending the duration of client portfolios and will continue to do so as long as yields are at or above 4.0%.  The combined impact on performance from a generous amount of income and some capital gain should result in an attractive total return.  We expect intermediate bonds will provide investors with a 5% - 6% return this year.  The recent 40 – 50 basis point backup in yields creates an excellent environment for adding fixed-income securities to the portfolio. 

One of our favorite securities at this time is AAA rated Residential Mortgage-Backed Securities (RMBS).  These are not backed by the U.S. government, but instead are structured in such a manner that any losses get absorbed by the lower-rated tranches.  Most AAA super senior classes are issued with 15% credit support.  Given the loan-to-value ratios on the underlying mortgages are near 60%, defaults are usually rare.  Yields are very generous with bonds that are structured with a 5-year average life at issuance and trade with a yield at or above 5%.  The yield spread exceeds 100 basis points. Prepayment protection is provided by finding lower-coupon tranches selling at a discount to par.  If prepayments increase, the yield can rise to 7% to 8%. The RMBS market has been in existence for decades and is typically very liquid.     

Another idea we find very attractive is government backed Mortgage-Backed Securities (MBS).  There is no credit risk as all the mortgages have the backing of the government.  There are numerous maturities and coupons available. Our favorite is a 20-year pool with a 4.5% coupon.  These trade at 98.375 and have a 5.5-year average life.  The yield is 4.85% which translates to a yield spread of 95 basis points.  Any increase in prepayments will boost the yield like the RMBS above.  Liquidity is often excellent as this is a huge market.  The investor receives monthly principal and interest payments.  An increase in the prepayment speed caused by lower mortgage rates will increase the yield to 6% or greater.      

Another option is to buy a deeply discounted 20-year mortgage-backed security (MBS).  An example would be an MBS issued 3 years ago.  It has a 3.0% coupon, sells for $89, has a 6-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.

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 that has very generous yield spreads is financials.  Generically we will look at an example 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 bond yield 5.20%.  This is an attractive yield for a too-big-to-fail financial institution.  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 trades at 4.40%.

We have been very consistent in our view that investors should move to the longer end of their duration range.  It’s taken longer than we thought but with elevated rates today it makes good sense.  One gets bombarded with new information on the market 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.             

 Q4 Interest Rate Outlook – Maestro, Or Perhaps the Gang That Can’t Shoot Straight

Our fixed income investing theme for 2024 was driven by the idea that sticky sources of inflation would drive yields higher in the first half of the year, as the market concluded that the Fed would not be able to get this bout of inflation under control.  The expectation for the back half of the year was that a restrictive policy, in the form of higher borrowing costs, would eventually weigh on the consumer and some institutions that operate at the margin, and signs of an economic slowdown would become more widespread.  In practice, housing and owners’ equivalent rent defied the influence that higher borrowing costs had on home affordability, which should have put downward pressure on pricing.  The lack of an adjustment in home prices may have created price support for single family housing substitutions.  Population growth has been referenced by the Fed and above-trend growth could also offer support for pricing in the face of decreased affordability, higher borrowing costs, and higher prices.  If it weren’t for the outsized rate cut in late September, immediately followed by a surprisingly strong job report in early October, our 2024 rate forecast would look quite sound. 

"People change their buying habits to adapt to the price realities."

Broadly we are seeing continued inflation in services and some disinflation for goods.  Housing and protein at the grocery store are areas that contribute to the inflation pain that people continue to feel.  It may be that whether you are talking about the feeling of misery in the form of elevated prices for housing and food, or if you are considering the higher “prices” that interest rates represent, the “shock” of operating in a higher price environment may have a half-life.  The misery may be there, but at a point you learn to operate in a higher “price” environment.  People change their buying habits to adapt to the price realities. Dinner out with friends may be adjusted to hosting friends for dinner at home.  Interest rates are higher than where they have been for much of the past 20 years, but they have been roughly 50% to 100% higher than the current environment during periods of prosperity during the past 30 years.  That is not to say that consumers are immune to higher borrowing costs.  Credit card balances are near record highs and the average interest rate applicable to credit card debt is now greater than 20%.  At a point, “price” matters in the supply/demand equation but markets and people can operate beyond the boundaries of rational economic behavior for periods of time.

Turning our focus to one of the rates that the market will be watching closely, the Fed Funds Rate will determine the near-term fate of both stocks and bonds.  An often-watched indicator of the appropriateness of Fed policy, the Taylor Rule (a calculation of where the Fed Funds Rate should be as a function of inflation and the output capacity of the economy) as presented by the St. Louis Fed suggests that the current Fed Funds Rate is nearly perfectly positioned. This may be problematic for the Fed because Chair Powell’s comments, and the dramatic start to this easing cycle, have positioned the market to expect additional rate cuts in 2024, and roughly another 100 basis points of easing in 2025.  Since the 50 basis point cut in September, the economic data have put the Fed in an uncomfortable position.  As we look at the Fed’s dual mandate of price stability and full employment, we have seen over the past two weeks surprise numbers that suggest the job market is robust and the progress toward wrangling inflation has modestly reversed.  The September Non-Farm Payroll number came in above all analyst estimates, with job growth of 245,000 jobs as compared to expectations of 150,000 and the unemployment rate fell to 4.1%.  Perhaps even more problematic for the Fed, wage growth was 4% on a year-over-year basis. That is not a bad development on its face, but in the context of the surprise uptick in inflation in September, where Core CPI increased 3.3% and Headline CPI increased 2.4% on a year-over-year basis, consumers are experiencing real wage growth and employers are feeling continued wage cost pressures.  Whereas we can celebrate people having wages that allow them to improve their quality of life, the “negatives” are that the wage cost pressures may flow through to prices of goods and services, and it may stimulate an updraft in spending; both are developments that could impede the ability of the Fed to make progress toward their long-term average inflation goals of 2%. The prices of goods, on a year-over-year basis continue to be a source of disinflation, and the areas contributing to the updraft in inflation continue to be in the services sector. Food, shelter, and apparel were some of the largest percentage growth contributors to inflationary pressures. Since 4.1% unemployment is generally thought to be “full employment” and with the short-term pause in progress toward the Fed’s inflation goals, the Fed may have put themselves in a difficult position regarding how to communicate to the market and what policy moves are appropriate, especially given the long lag that Fed policy tends to have on the economy. We don’t subscribe to the idea that the Fed is stuck with an obligation to engage in an easing cycle.  That said, the FOMC voting members are human decision-makers and they can make the same decision “anchoring” mistakes we all often make (anchoring your forecast for the future on your past expectations). On that basis, it may be difficult to suspend additional eases, which may put the inflation-fighting goal at risk until the data offer a clear policy path direction.  After all the talk of being cognizant of the failed policy of the 80’s and the tough medicine required during the Volker years to “break the back” of inflation, it will be interesting to see if the current Fed policy rhymes with the mistaken policy of past. 

The unknowable issue going forward is whether real wage growth will result in more spending or less misery.  From the vantage point of people who don’t worry about interest costs on credit card debt and elevated food, shelter, and clothing costs, the question seems dramatic.  For the people with little room in their budget for unforeseen expenses, it is the question.  Having wages surpass inflation by 1.6% is marginally nice but it may be a meaningless influence on some people’s ability to spend.  Although people at the margin have been repeatedly told that the economy is strong and they should be feeling good, they simply don’t.  In September, consumer sentiment fell by the most in three years.  The Conference Board’s measure of sentiment declined by 6.9 points to 98.7, the largest drop since August of 2021.  Concerns about the labor market and the broader economy caused measures of current conditions and expectations for the next six months to decrease as well.  The percent of consumers who said jobs were plentiful decreased for a seventh straight month to 30.9%, which is the smallest reading since March of 2021.  It is the longest stretch of declines since 2008.  The percentage of consumers who said jobs were hard to get hit 18.3% which is also the highest reading since early 2021.  Consumers may be wiser than they are given credit for because small business owners, responsible for roughly 50% of the jobs in the U.S., became more pessimistic about profitability and business conditions in August.  For a better understanding of what elevated amounts of debt and relatively high interest rates mean for a broad swath of consumers, we should dig into some related statistics.  In the second quarter of 2024, overall household debt increased by $109 billion to $17.8 trillion.  Balances on credit cards rose by $27 billion to a total of $1.14 trillion.  Auto loan balances rose by $10 billion to $1.63 trillion. That all adds up to a lot of trillions. Total consumer debt in delinquency stands at 3.2%.  The share of auto loan balances that are more than 30 days delinquent increased to 7.95%, the most since 2010.  The percentage of credit card debt that is delinquent rose to 9.05%, the most in roughly 12 years.  Balances on home equity lines of credit increased for the ninth consecutive quarter to $380 billion, the highest level since 2019 and approximately 20% above the level that was in place in late 2021.  People are choosing to (or needing to) tap credit and the cost to finance that credit is historically high.  Admittedly, we may be in an unusual state where there is a “Goldilocks” economy. You can point to a lot of metrics and conclude that there aren’t any obvious signs of weakness, but many people in the economy may not be enjoying the existence that the numbers would suggest. We expect diminished misery may be the dominating sentiment that may arise from the current mix of low unemployment, stable prices, and elevated debt burdens.  

The upcoming election seems like it will pose a smaller risk to bond yields than what could have been the case.  Our concern had been that single party rule would have led to continued deficits and an elevated debt burden for the U.S.  Increasingly, it is looking like there will be a divided government.  That suggests some of the 2017 tax cuts may expire in 2025 and some election year spending promises will fade back into the fantasyland from which they came.  That landscape doesn’t position us to solve large problems, it is more postured to react to crises, but it tends to offer markets the perceived safety of modest policy changes and a more modest increase in the federal debt, now topping $35 trillion.  There will almost certainly be malinvestment with the next administration, but the truly offensive use of scarce resources may be tabled for future unserious politicians.  Although it is difficult to predict what geopolitical influence will do for both the domestic and global economies, trade policy and the risk of trade wars are emerging as a risk to growth.  Short term, tariffs can nudge change, improve unequal footing, and raise revenue.  It also can act as a more widespread tax, seemingly without the political process needed to raise taxes and bringing it into the light of day.  Longer term, if trade policy and tariffs are used as a baseball bat to antagonize trade partners, it can be destabilizing as it can siphon from global growth and living standards.  A functioning trade relationship between competitors is a better place from which to negotiate as compared to a position where benefits of economic cooperation don’t exist.  The world is awash in existing and potential conflicts.  Recently it came out that the intelligence community brought the probability that Russia would use tactical nuclear weapons against Ukraine as high as 50% during the conflict.  Those are odds that since the 1980’s were unthinkable.  Intelligent trade likely plays a role in improved global peace. There seems to be an elevated risk of global conflict that would quickly turn our Goldilocks economy into something much less “perfect.”

Our outlook for interest rates is that consumer sentiment and the cost of credit will pull down consumer demand.  The recent job market strength and stable inflation numbers will give way to a slowing consumer.  In response, yields will have the standard knee-jerk reaction to trend lower. Mothballed campaign promises and the prospects of divided government resulting in some tax cuts expiring in 2025 may offer hope for diminished deficits and a slowing in the growth of the federal debt.  That could allow the longer end of the yield curve to trend lower and shorter-term rates will track with an eventual resumption of the Fed’s easing cycle. The central question is whether the Fed can kill inflation without some economic pain.  That is a feat that has been achieved about 10% of the time in modern history.  Optimism and yields may see some life once election uncertainty passes.  Once we pass the uncertainty, hopefully before January of 2025, reality should set in, and we should see yields fall.  A mild recession of between one and two quarters remains our base case (if we can have two quarters of negative growth without it being a “recession” we think it is fair to call for a one quarter contraction to be a recession in the eyes of the population).  We can imagine a scenario where 10-year Treasuries retest the 4.50% area and drift below 3% during the weakest part of 2025.  Long-term, especially if the U.S. loses its last remaining “Aaa” debt rating from Moody’s, the trajectory of borrowing costs, feels like a move higher is the more natural state.  That wouldn’t be without consequence.  Currently, the cost of federal debt interest payments account for 13% of public spending.  The U.S. needs to position itself for growth and some degree of fiscal discipline, because the path of austerity seems to present a challenging future for unserious people with their deserved representatives.       

Summary – Gravity Always Wins

It may be that the Fed made a large first move in the easing cycle to give themselves space to let policy continue to work.  It could also be the case that the strong move allows for Quantitative Tightening to continue to quietly shrink the Fed’s balance sheet for the next crisis response.  In response to Covid, we pumped unfathomable amounts of stimulus into the economy.  What if the budget challenges that some school districts are facing from the abundance of funds followed by the hollow reality of normalcy, are a microcosm of what may be expected by the domestic economy?  Growth feels like the only elixir that can keep the economic hangover at bay.  Reshoring production, productivity gains that should arise from AI, strategic investment in semiconductors, and addressing demand for green energy technologies, may stimulate growth but perhaps not in time for gravity to exact a natural response to the massive stimulus of the past several years.  Worse yet, what if individuals and institutions have been conditioned to think that the degree of deficit spending is sustainable?  Given enough time, what goes up eventually comes down.  Interest rates rose in response to stimulus and as that influence is removed, the equilibrium for interest rates should be lower.

The updraft in inflation relative to expectations along with the belief that the Fed has the market’s back offers a near-term basis for rates to trend higher.  Declining job market confidence, elevated prices for unavoidable segments of household budgets, and the cost of credit should drag the pace of consumer activity lower.  We expect inflationary pressures and longer bond yields will follow.  We may not experience an official recession in 2025, but the average person on the street will feel like they are in a recession.  Historically stingy yield spreads should normalize and that will likely eat into future bond returns, even if there are total return gains that arise from interest rates falling.  This may become a larger influence at the end of the Fed’s Bank Term Lending Facility (BTLF) that eased liquidity burdens during the difficult environment that banks experienced in early 2023.  As the Fed reduces rates, the appeal of the BTLF decreases and banks may pay down loans more rapidly, which will effectively drain liquidity from the banking system.  Less liquidity typically means either less available credit or a higher cost of financing. We are not predicting it will cause a credit crunch, but it would make credit marginally less available.  In the face of a pause in the Fed’s rate moves, caused by a solid job market and stable yet above target pace of inflation, a barbell strategy continues to be a preferred strategy.  The short segment of the strategy will see lower yields, but not as fast as originally expected, and both the political gridlock and slowing economy should pose less of a risk for the longer maturity part of the strategy. Yields are historically high as compared to the past 20 years, so lock that in and there is a good chance for some price appreciation as the market reacts in a normal fashion to a slowing economy.  A longer-term risk remains to long bonds if we can’t get our fiscal house in order, but the immediacy of that risk seems to be an issue for another day.  Whatever the outcome of the election, there may be peace in the simple truth (whatever your political leaning may be) that the end of the world as you know it is not the end of the world. 

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