Insights

Will “Higher for Longer” Ever End?

Following the dramatic start of the Fed’s easing “cycle” in September, bond yields have moved higher. Some of the move can be attributed to a stall in the progress in moving inflation down to the Fed’s long-term goal of 2% and part of the move may be due to deficit concerns related to speculation on the outcome of President-Elect Trump’s policies.  There is talk of tariffs, deportations, onshoring manufacturing, and additional tax cuts.  One can argue that any of these proposals could increase inflationary pressures, but the reality is that nobody knows which proposals will be enacted, whether they will be nuanced changes or blunt force adjustments, and how long it will take for policy to turn into action.  A balanced evaluation of the proposals embraces the reality that we won’t know the outcome until we see how the Trump presidency unfolds.  As is often the case, if missteps occur that negatively impact voters, a course correction is likely possible.    Yields have decidedly moved in a direction that suggests the market believes some mix of inflationary pressures and persistent federal deficits are a near certainty in the future.

Consumer sentiment remains robust.  The manufacturing sector continues to contract, and the service sector continues to expand. The number of jobs per seeker has risen to 1.1, up from 1.0, and the unemployment rate has bobbled between 4.1% and 4.2% which is essentially “full employment.” On a year-over-year basis average hourly earnings are 3.9% higher, so the average workers’ wages are outpacing the rate of inflation.  Also, on a year-over-year basis headline CPI is growing by 2.7%, core CPI is 3.3% higher, headline PCE is higher by 2.4% and core PCE has increased by 2.8%.  While many measures of inflation are approaching a comfortable position, the recent ISM Non-Manufacturing ISM index “prices” subcomponent jumped from a reading of 58.2 in November to 64.4 in December.  It was the highest reading since 2023 and the 91^st consecutive month of price increases in the service sector.  The shock of the significant inflationary measure, in the most important area of the U.S. economy has pushed market expectations for the next Fed rate cut past July.  The Fed’s most recent “Dot Plot” indicates a likelihood of two rate cuts in 2025, and recently the market barometers suggest some possibility that cuts may total less than 50 basis points. 

"It is an unknowable landscape and frankly neither major political party has shown fiscal discipline in quite some time."

During the final quarter of 2024, a lack of progress in the Fed’s fight with inflation collided with a questionable Fed rate cut in December, and an “uncertainty” yield premium that may have been understandably introduced to the U.S. Treasury market. President-Elect Trump and his advisors don’t know what policies will move forward and what modifications and policy sacrifices will be needed to make his policies palatable enough to pass. Campaign promises suggest that fiscal discipline will be a consideration, but it seems the main strategy is to reduce regulation, foster a cheap energy policy, keep tax rates historically low, and hope to grow our way out of our debt and deficit challenges.  It is an unknowable landscape and frankly neither major political party has shown fiscal discipline in quite some time.  The market’s response to the unknowable, increasing the borrowing cost of the “risk-free” U.S. Treasury yield may the most prudent reaction.  If politics remains status quo, continued deficits and a burdensome debt to GDP ratio would call for higher rates.  Mass deportation of immigrants could increase employment costs.  Tariffs as a blunt force object could result in inflation or even stagflation.  If Trump’s growth initiatives work, inflation may find a new spark and the Fed may find itself needing to reverse policy.  If Trump’s policies fail, fiscal spending and stimulus may be the Hail Mary that is used to prop up the economy ahead of the mid-term elections or before the next Presidential election.  There are many outcomes where higher rates ahead of reality playing out seems likely.

Over the course of the quarter, 10-year Treasury yields increased from 3.78% to 4.57% and 10-year high quality municipal yields rose from a yield of 2.63% to a yield of 3.12% as the quarter ended.  Since the start of the year, 10-year Treasury yields increased by 119 basis points and 10-year muni yields rose by 86 basis points.    Taxable bond indexes experienced year-to-date total returns of between 1.25% to 2.5% and municipal bond indexes experienced total returns of between a loss of 0.33% and gains of 1% for the year-to-date.  The strongest returns for bonds this past year have been focused on the shortest-term indexes and the lower quality space.  With the degree of uncertainty in the market and the likelihood of a slower pace of Fed rate cuts in 2025, the “safe” short term area of the bond market seems to be commanding some allocation in fixed-income portfolios.    

Q1 Interest Rate Outlook – The Forgotten Consumer

Much has been said about whether the Fed can orchestrate a soft landing or possibly “no landing” from the double barrel growth period that followed the pandemic due to massive fiscal and monetary stimulus.  Inflation has made progress toward something less painful for the population, risk asset prices are higher, corporate earnings are generally growing, people who want to work have job opportunities, and no obvious signs of a change in direction are flashing warning lights.  Somehow in all the amazement in the Fed’s recent accomplishment, the market’s short memory is failing them, that the missed call for “transitory inflation” accompanied with an overly accommodative Fed led to the level of inflation that caused pain for so many families.  The December rate cut by the Fed was questionable.  Progress toward a healthy level of inflation had already stalled, and since that cut we have seen a troubling uptick in inflationary signs in the service sector and expectations for inflation have seen a significant jump.  Our observation is that perception (expectations) often becomes reality in the direction of inflation.  Purely speculation, it may be that cutting the rate offers cover for the Fed to continue Quantitative Tightening, shrinking their balance sheet, to give them the ability to face the next major market event. 

"The old investment adage of 'buy when everyone is selling and sell when everyone is buying' would seem to suggest caution given the enthusiasm in the risk markets."

Although the stock and bond markets have had a bad couple of weeks, both have seen prices decline in the last week of 2024 and the first week of 2025, general exuberance toward risk is at a level we find to be uncomfortable.  Early in Q4, stock market investor optimism (as measured by asset manager net long S&P 500 futures positions) displayed the biggest jump since recovering from the depths of the pandemic in June of 2020.  To introduce a “horse sense” perspective, when the internet bubble was popping in 2001, Warren Buffet said measuring total publicly traded stock market capitalization as a percentage of the economy (GDP) was “probably the best single measure of where valuations stand at any given moment.” The supporting logic is probably that since publicly traded companies get their profit from “the economy” there should be a relationship between the value and output of the economy and corporate valuations.  From a commonsense standpoint, especially if you are a contrarian investor, the idea that valuations will mean-revert is appealing.  To put some numbers on this metric, the peak of this number before the Great Depression was 109%.  It grew to an all-time zenith of 190% in March of 2000, and has moved lower to its current point at 133%.  Had you been out of the market from March of 2000 until now, you would have missed out on a holding period price return of almost 300% or approximately an annualized price return of under 6% over nearly 25 years – if you include dividends reinvested in the index the holding period total return increases to more than 500% and the annualized total return was better than 7.5%.  Given Mr. Buffet’s recent stock sales, it seems that he believes stock valuations are outsized and that cash equivalent securities offers a better risk-adjusted return prospect.  Since the S&P 500 index bottomed in 2022, stocks are up roughly 70%!  A couple examples of investor “enthusiasm” may be useful.  First the chipmaker Broadcom has a growth rate that is slower than Proctor & Gamble but Broadcom trades at 21 times revenue while P&G trades for five times. The price-to-earnings ratio to growth ratio (PEG ratio) for P&G is 3.3 while Broadcom is 1.7.  This is not a buy or sell recommendation of any stock, but it demonstrates how much more the market is willing to pay for a dollar of earnings or a percentage point of growth if the stock is in the “right” sector. At the extreme of market silliness is the fact that investors are willing to pay for MicroStrategy’s stock (a Bitcoin investment) 150% of the value of the underlying asset.  In December, the market cap of the stock was approaching $120 billion at the same time they had a $47 billion hoard of Bitcoin. Again, not a recommendation to buy or sell, but it seems that “investors” have become detached from the economics of their investments, or perhaps people value convenience so much they will pay 150% of the value of an asset they can easily procure themselves. According to Apollo Global in a recent survey, since the start of 2009, currently a record high percent of investors thinks there is less than a 10% chance of a market crash.  The old investment adage of “buy when everyone is selling and sell when everyone is buying” would seem to suggest caution given the enthusiasm in the risk markets.

The exuberance isn’t limited to the stock market.  The bond market is getting in on all the positivity too. Risk spreads (the incremental yield investors earn for accepting credit risk for a bond, relative to a like-maturity Treasury) for investment grade bond hit the lowest level since 1998 during the 4^th quarter.  The high yield (also known as “junk bond”) sector has seen similar spread tightening. It is a concern if the economy slows and the risk of corporate defaults increases, but there is a nuanced change in the bond market that makes the stingy spread environment less alarming. Since the pandemic we have just seen the second largest wave of credit upgrades in the past 10 years.  So, although spreads are historically “tight” the perceived quality of the index (the universe of corporate bonds) is of a higher quality.  Also, factoring into an analysis of bond spreads is the fact that since we have been in a higher yield environment for the past couple of years, market coupons for many outstanding bonds are higher than they have been for much of the past 15 years.  Higher coupons tend to reduce the interest rate risk of a bond and at a large scale, the composition of the indexes now reflects most bonds having larger coupons and less interest rate environment sensitivity, meaning the index has less interest rate risk (duration) relative to where it has been for a long time. Bond spreads are at a point where the likelihood of further material tightening is less likely and widening is more likely, especially if the economy slows.  The chances that this dynamic works against bond valuations is something we have incorporated into our strategy.  As a result, we favor high quality issuers with stable earnings relative to their debt burden and Treasuries, because that posture allows us to capture much of the benefits of the higher yield environment without as much risk of the spread widening environment that should accompany the next economic slowdown.  Whether it is stocks or bonds, there is a lot of “perfection” priced into the markets. If reality doesn’t match up with perfection, price adjustments or stagnation are a likely outcome.  The U.S. economy, markets, corporate structures, demographics and culture are all different than Japan’s but as an example of an extended recovery period when the market normalizes after exuberance, it took investors in the Nikkei 225 Index in late 1989 approximately 34 years for their investment values to recover.  Exuberance can feel “fun,” but it can also be the cause of a lot of hardship.          

Our forecast for 2024 was that in the back half of the year, consumers would finally succumb to the stresses that surround the bulk of the population.  We also suggested that the risk of single party rule, and resulting profligate spending, was limited.  Perhaps we should stick to economic and market forecasts and leave the political guesswork to the “experts.”  The lack of any major blowups and a consumer who is somehow treading water allowed for many markets to be near record highs as the year ended.  Fed officials have generally indicated that additional cuts would need to be preceded by softening in the job market or months of stagnant inflation or some further improvement in inflation.  Chicago Fed President Austan Goolsbee recently pointed out that over the past 6 months, the PCE has been running at an annualized rate of 1.9%, so although year-over-year numbers indicate the Fed has more work to do, he seems to believe that more recent segments of the metric suggest the inflation fight has largely been won.

"We think the consumer may experience some shocks while the federal government is (hopefully) getting its fiscal house in order."

Last quarter we detailed the elevated levels of credit outstanding as well as the dangerous trends in credit delinquency metrics.  Although recent wage growth statistics suggest that people’s incomes are currently keeping pace with broad measures of inflation, near record levels of debt being carried at interest rates in excess of 20% should overwhelm many family budgets. Given the election outcome, the holiday that many student loan borrowers have enjoyed is about to be over.  That will introduce an additional drag on many borrowers’ ability to spend.  Another area that isn’t postured to offer any relief is home affordability.  According to Nerdwallet.com, 30-year mortgage rates are nearly 7% and there doesn’t seem to be a significant impetus for home prices to plummet (although marginally there seems to be a possibility of some domestic population growth shrinkage in the short term).  The point is that in our bifurcated economy, there will be a large number of consumers who have been thrown so many credit “lifelines,” which are eventually anchors around their necks, that a day of reckoning as it relates to their ability to consume will come.  Debt forbearance, buy now pay later, store credit cards at 25% interest rates, personal responsibility, and freedoms are good, but the sad truth is a drowning man will grab on to anything, even if you throw him a stone.  We think the consumer may experience some shocks while the federal government is (hopefully) getting its fiscal house in order. It may not happen in 2025 but a recalibration for the consumer seems long overdue.

Below the surface of the seemingly calm water are a lot of jagged rocks that could portend our next economic event.  The money supply continues to shrink, economic activity tends to correlate with population growth, and the degree of political uncertainty through one party rule as well because of the complete division and demonization the two parties project on each other, all threaten the scenario of a smooth path toward economic growth.  In past quarters we highlighted looming areas of potential challenge.  Commercial real estate (CRE) investors may have hoped for a lower cost financing environment to help them push off the day of office space reckoning to another day.  The higher yield environment is providing them with no such relief.  From Manhattan to Minneapolis and Los Angeles, stories of CRE losses in the range of 60% or more are not hard to uncover.  Private credit, a recent darling of the industry, is seeing assets piling into this sector, but the private credit market currently offers little in the way of an illiquidity yield premium over publicly traded debt securities.  The problem with illiquid securities is that when markets misbehave, the cost of finding liquidity (getting out of the investment) can be ugly.  As a result, we are always looking for early signs of economic weakening and market jitters.  One such example is the 13% to 24% chance the online betting forums are placing on the WHO declaring the H5N1 Avian Flu (the “Bird Flu”) as a pandemic by the end of 2025. Over 60 human cases in the U.S. have been confirmed since April and if it mutates to the point of human-to-human transmission health officials fear the outcome would be catastrophic.  Hopefully you held on to your personal protective equipment. 

A metric we are watching is the number of people with temporary positions.  Recently the number of temporary workers has been declining and that tends to occur ahead of softening of the employment environment and recessions.  What feels material about the change is that following the November election, small business optimism made a large jump, and yet the use of temporary workers continues to decline.  Partner that with large employers announcing that they are moving back to five day in office work weeks, which will push some less committed employees to quit or retire, and it feels like companies are positioning themselves to be operating in a leaner and meaner fashion.  It is natural for the pendulum to swing back in the other direction for the balance of power between employers and employees.  Absent a traditional business cycle “cleaning of house” for underperforming employees, it may be a trend that catches hold in the coming months. Recently Alphabet (Google’s parent company) announced staffing redundancy reductions of 12,000 employees, totaling about 6% of their workforce.  JP Morgan announced in office workweeks.  Employer interest in operating more efficiently may weigh on future wage gains and economic activity.       

Earlier we mentioned that in the face of fiscal policy uncertainty, a market response that involved taking the cost of “risk-free” U.S. Treasury financing higher seemed prudent. There seem to be several supply/demand influences that are worth examining.  The obvious one is the supply side.  Not knowing the path of fiscal spending related to what Trump’s policies will be put forward, which ones were campaign promises, and what the end result will be of the political sausage-making exercise, anticipating ongoing federal deficits feels like the projection of least resistance.  On the demand side of the analysis, you have the largest buyer/owner of U.S. Treasuries letting their investments roll off through the QT program.  A reduction in foreign buying of U.S. Treasuries will not help the situation.  As recently as 2018, the largest foreign holder of U.S. debt, China has been a net seller of Treasuries for most of the past five years.  The result of uncertain supply with negative demand influences has increased the amount of yield investors want for holding longer term U.S. Treasury debt.  A measure of this bond market anxiety, called the Term Premium, recently hit the highest level since 2015.  It means the consequences of past federal deficits have increasing consequences and the penalty for continuing down the same path will likely be greater than we have been operating under over the past decade. 2025 will be the third straight year with deficits in excess of 6% of GDP growth.  President-Elect Trump’s pick for Treasury Secretary, Scott Bessent, has discussed what he calls his “3-3-3 plan” which involves boosting economic growth to 3% a year through deregulation and lower taxes, while reducing the federal deficit to 3% of GDP and aiding the economy with cheap energy, by increasing U.S. energy production by 3 million barrels per day.  Since there are a multitude of scenarios where some aspects of the 3-3-3 plan can work at cross purposes with each other, we expect the term premium will remain elevated until policy unfolds into reality and a directional hunch is presented to the markets about the direction of the federal deficits and related debt issuance.   

Last quarter we suggested 10-year Treasuries would retest the 4.50% area and drift below 3% during the weakest part of 2025.  Higher for longer seems like it will hold for much of this year.  If 10-year Treasuries break out above 5% it would seem we will test a level between closer to 5.5% and the floor we are now forecasting is 3%.  If we can get our fiscal house in order or if any number of events that could cause a “flight to quality” and trigger a run to the safety of U.S. Treasuries, interest rates should fall.  Fed policy could change on a dime, and it seems like bonds are postured to see decent returns in 2025.  Historically, purchased yield on a bond has a high correlation to forward-looking total return.  Stated another way, the better the yield at which you buy a bond, the better your total return in the future tends to be realized.        

Municipal Market Developments – Municipal Bonds Become the Talk of the Town?

There aren’t many significant developments in the municipal bond market since last quarter, so we will offer an outlook for the muni bond space in 2025 as well as some yearend observations.  The conversation this year in the municipal bond space will be whether federal tax exemption is put into question.  We would offer two views on this, but the punchline is that we expect nothing will change.  If the federal government could do away with the federal tax exemption of bonds issued by states and political subdivisions within, the savings would be only $37 billion a year.  Somewhat meaningless in an effort to reach $1 trillion to $2 trillion in cost cuts.  Perhaps more important, it would be like taking money from one pocket and putting it in the other.  The reduction in interest cost for state municipal borrowers would need to be funded in one of several ways by a subset of the same taxpayers that are effectively providing the interest cost subsidy.  A case could be made that high debt states (relative to economic activity and the size of their population) benefit more from the exemption than do low debt states.  As we have said many times in the past, the fact that federal debt (Treasuries) is not taxed at the state level and state debt (munis) is not taxed at the federal level, provides an important area where one government doesn’t influence the policies of another government.  Attempts to tinker with this position have been met with failure in the past and since there is not a real cost savings to be gained, it seems the risk of a change in the tax landscape for munis is limited. 

From a total return standpoint, munis underperformed taxable bond indexes in 2024.  At the same time, municipal bond yields as compared to similar-maturity Treasuries are low.  Stated another way, municipal bonds are “expensive” as compared to taxable bonds. Institutions have been shying away from munis because they are expensive and some large historical buyers, mainly banks, are staying put with their investment portfolio positioning (letting time pass so the interest rate risk position diminishes for their investments). It has been individuals, largely through their participation in municipal separately managed accounts and exchange traded funds, who are driving most of the demand for muni bonds. On a technical basis, it is not an attractive time to buy munis, but at the 100,000 foot level, yields are the highest they have been for a long time, so investors may not care as much about the relative value of the municipal sector, they are looking at the absolute level of yields and wanting to build streams of tax-efficient income at historically attractive levels.  Many in the industry call it FOMO, but it may be a form of horse sense that isn’t often bestowed upon individual investors. 

"Could it be that municipal bonds will become dinner party talk in 2025?"

January tends to be a strong month for municipal bond performance as issuers are not fully into the market, but unrelenting investor cashflows are seeking investment options. Around the time of the election, municipal bond issuance came to a standstill and this January, issuance is hovering at 99% of the average monthly issuance level for the past year.  We don’t expect the “January Effect” will help muni performance this January.  Other areas to touch on include a reminder of why essential purpose municipal bonds are more attractive in our opinion as compared to other sectors of the muni bond market.  Looking at the default activity in the municipal market in 2024, the challenges were focused in the areas of continuing care retirement communities, areas of the market that are better served through different financing vehicles (such as a cancer treatment research facility), and private colleges. The operational challenges and financing flaws that cause losses in these areas won’t change anytime soon (and they may get worse).  A recent Philadelphia Fed study offers a scenario where there is a 15% drop in prospective students, which could result in 80 additional college closures, impacting 100,000 students and nearly 21,000 staff.  To the positive, munis as an asset class have some nice things going for them.  First, muni yields are near the highest levels experienced for most of the past 15 years.  Second, munis have historically done well when the Fed has been in an easing cycle, likely due to the high quality and perpetual entity nature of many municipal entities, so when the economy slows, people move toward Treasuries and high quality issuers.  Third, high grade municipal bonds have enjoyed an annual return over the past 20 years of 3.16%.  When you combine that with a 0.1% average annual default rate (Source: Moody’s Rating) that suggests a nice return relative to the risk of the investment, especially when the current yield environment is factored.  Could it be that municipal bonds will become dinner party talk in 2025?  We can only hope our social calendar fills up as a result.     

Strategy and Summary – Who Knows?

Sometimes it is very liberating to embrace the reality that we don’t know what the future holds.  The next two years offer the possibility of an environment where acknowledging the folly of forecasting, while having the experience to discern the key emerging developments from the market noise may be helpful in navigating the rough waters.  Nobody knows what policies will see the light of day, to what degree they will be enacted, and how they will impact the economy.  It appears that President-Elect Trump has made some serious picks for his cabinet.  We see it as a positive that in the mix it appears that he picked some people who don’t come off as sycophants (understanding full well that the cabinet serves at the president’s pleasure).  We are in serious times, where the consequences of failure feel elevated.  Can meaningful deficit reduction occur at the same time as we pursue an agenda of economic growth?  We better hope so.

A couple of paths we can envision for the economy involve growth policies, and potentially tariff policy, that could stoke inflation.  That would likely drive bond yields, or the term premium, higher.  Another path is if Trump’s policies don’t work and a fiscal spending “Hail Mary” is needed for political purposes.  Our expectation is that the likely path is a push and pull economy where waves of positivity are met with some shocks to the system.  At a minimum it will be “interesting” to have a non-legacy system thinker like Elon Musk attempting to bring the level of efficiency and operational change to government that has generally been reserved for corporations and shoe-string budget not-for-profits.  In the seesaw environment it seems like after some period of hope, the consumer will succumb to the consequences of too many obligations and either too few assets or not enough cashflow.  We just don’t see the productivity gains or wage improvement to make that outcome a likely scenario over the next couple of years. 

What we can observe from history is that for a bond portfolio, higher purchased yield tends to mean favorable total returns.  We expect that historically high borrowing costs, along with record levels of debt for both the consumer as well as for the U.S. government demands a change in trajectory.  The “weight” of the consequences of excessive borrowing may be its own governor as it relates to a continuation of bad habits.  From a strategy standpoint, the Fed seems to be on hold until the last half of 2025.  It makes short-term bonds a stable part of the continuation of our barbell strategy.  Cash equivalents and short-term bonds offer an attractive yield without much interest rate risk and the shorter maturities offer the ability to have a dynamic ability to respond to future credit concerns.  On the other side of the barbell, we like high quality issues spread through the 5-year area of the yield curve through the 10-year part of the curve.  It offers investors approximately 90% to 96% of the yield of the 30-year segment of the yield curve without the interest rate risk. We anticipate that when the forgotten consumer displays their exhaustion, the economy will slow, and the longer segment of our barbell strategy will see solid returns. 

Our thoughts are with all the people impacted by the California wildfires.       

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