Over the last six months, we’ve seen significant volatility in the bond market. Six months ago, the Federal Reserve had just finished raising interest rates to 5.25% and we suggested that the Fed was closer to the end of its cycle than the beginning. We continued to suggest considering callable Government Sponsored Agencies (“GSAs”), as they were offering significant spreads relative to comparable Treasuries, as well as many bullets (non-callable bonds). We warned our readers then to closely monitor their client accounts for called bonds, as we expected interest rate volatility to continue.
The Fed has raised its benchmark interest rate once more, to a range of 5.25% to 5.5%. Longer-term interest rates moved higher, with the 10-year Treasury briefly yielding above 5.0%, while corporate and agency yields followed in tandem. That 5% level appears to have been the high watermark for Treasury yields in the recent environment. Almost immediately, rates began to fall (causing bond prices to rise in investment portfolios) due to a series of dovish economic data announcements that arrived in relatively quick succession.
Cooling Trends
Inflationary data came in below expectations. The headline Consumer Price Index (“CPI”) rose 0.1% in November, or 3.1% from a year ago. Core CPI, which removes the volatile food and energy categories, came in slightly hotter at +0.4% or +4.0% from a year ago. While we may not be at the Fed’s 2.0% target, inflation appears to be cooling.
Jobs data came in slightly ahead of expectations but is pointing to a cooling of the labor market also. Initial jobless claims came in at 202,000, while continuing claims showed 1.87 million Americans looking for work. Perhaps more troubling, the Labor Department shows 1.3 available jobs for every job seeker, down from nearly 2.0 jobs earlier in the year (i.e., there are fewer open positions waiting to be filled).
The Latest ‘Dot Plot’
Finally, on December 13, the Federal Reserve Open Market Committee announced that it would maintain its benchmark rate at 5.25% to 5.5% but noted, “Recent indicators suggest that growth of economic activity has slowed from its strong pace in the third quarter. Job gains have moderated … but remain strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated …Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring and inflation.”
However, it was the Fed’s “dot plot” that released the doves, as the Fed’s indication of about three interest rate cuts in 2024 caused an immediate sigh of relief in the markets. Interest rates fell almost immediately, as bond traders quickly began to reprice their inventory. At least one bank stopped orders on a new issue it had just launched. The much-anticipated Fed pivot appears nigh!
How Should Advisors Position Clients in the Current Environment?
As of this writing, yields on many benchmark securities have fallen significantly. The 10-year Treasury yield, for example, has recently broken below its 200-day moving average, and is currently signaling that the uptrend in yields we have been witnessing since 2021 is over. A second interpretation is that the bond rally has overshot and yields will likely find support around current levels. We tend to believe the latter. As with stocks, interest rates will sometimes see pull-backs, even within a sustained rally or trend.
As a result, we expect to see continued volatility in interest rates as we move through 2024. It is unlikely that rates will go straight up or down from here. Even at 4%, Treasury yields are up significantly from two years ago, meaning that investors can continue to benefit from higher rates. As a reminder, when discussing interest rates, for every yin, there is a yang. For every borrower (person or corporation), there is an investor (such as a retiree, mutual fund, or financial institution), and part of the market’s job is to find a reasonable balance between the two.
Weigh These Factors
Our general opinion: Continue to ladder out your maturities. Don’t be afraid to go out longer if attractive opportunities present themselves. We still advise maintaining some liquidity in client portfolios, so you are not forced to sell at the wrong time.
Also be wary of credit quality and don’t stretch too far for yield. Stay with investment-grade bonds, as we may not be out of the macro-economic woods yet. Credit conditions are still relatively tight and could present a problem for cash-strapped companies. For instance, commercial lending activity and real estate lending standards have tightened at 65% of banks, while demand for new construction/development loans has contracted by 52%, according to the latest senior lending officer filings.
This presents a good time to review your clients’ asset allocations. Stocks have had a strong 2023 and may have become overweighted in some client portfolios. This is especially true for those clients that became unnerved by the sell-off in 2022. After all, bonds still offer respectable yields vs. recent history.
Additionally, many bond mutual funds and ETFs have enjoyed a strong uptick in the last few days. On the equity side, prices for many “bond proxies” — high-dividend, low-growth stocks in the utilities, financial, real estate (e.g., REITs), and consumer staples sectors — have moved higher as rates have fallen.
Meanwhile, falling rates may present an opportunity to exit yield-sensitive positions that caused concerns when rates were higher. Finally, there may still be time to do some last-minute tax loss harvesting in 2023, though that window is quickly closing.
In a nutshell, we expect to see a slowing 2024 economy in which both growth and inflation pressures may subside. This could make the potential spread between returns in fixed income and equity markets narrower than expected, potentially producing strong returns for fixed-income investors and the traditional balanced portfolio.
Christopher Baccella, CFA, is a wealth advisor with Mariner Wealth Advisors. He develops personalized wealth management solutions for clients to help them achieve their goals and to grow and protect their wealth, and provides investment management services to institutional clients. Chris has over 16 years of experience in the wealth management industry. He can be reached at chris.baccella@marinerwealthadvisors.com. Click here for disclosures.
