Written as of October 13, 2023.
View the Nicola Wealth Investment Returns: September 2023
Highlights this Month
- Factors influencing forecasted decline in 10-year rates.
- Comparisons to the 1987 market crash and yield curve dynamics.
- Impact of higher 10-year rates on financial conditions.
- Balancing the impact on inflation and the risk of a recession.
- Positive signs in recent inflation data.
- The Fed's potential policy shift and the role of bond vigilantes.
- Drivers of rising yields and the uncertainty ahead.
September in Review
September lived up to its reputation as historically the worst month of the year for returns. The S&P/TSX saw a decline of -3.3% (total return in Canadian dollars), the S&P 500 dropped by -4.8% (total return in U.S. dollars), and the NASDAQ decreased by -5.8% (total return in U.S. dollars). The S&P 500 experienced its second consecutive losing month, marking the largest decline since December. During the third quarter, the S&P 500 was down by -3.3%, but it has still managed a healthy year-to-date gain of 13.1%. However, market breadth continues to be a concern, with the S&P 500 Equal Weight Index decreasing by -5.1% last month and showing only a 1.8% gain year-to-date. According to Scotiabank, by late September, fewer than 50% of S&P 500 stocks were trading above their 200-day moving average.
Focus is on the bond market.
Throughout most of the year, the primary focus has been on the bond market rather than stocks. While stocks have faced a challenging couple of months, the bond market has endured a tough three years, with U.S. Treasuries on track for an unprecedented third consecutive year of declines. Back in 1788, there was a previous instance of 10-year bonds recording three consecutive years of losses. Financial historian Niall Fergusson recently highlighted that the increase in yields over the past three years is rivalled only by the period from 1979 to 1982 when Fed Chairman Paul Volcker aggressively tightened monetary policy to successfully combat inflation, though this action led to two recessions.
Unfortunately, the past two years have been particularly painful for bondholders. Last year, bond investors experienced a -15.7% loss, the worst since 1871. Year-to-date losses of nearly 10% indicate that bonds are on course for their most significant two-year drawdown in over a century and a half. In the last quarter (Q3), 10-year yields increased by 73 basis points to reach 4.57%, while 30-year yields rose by 84 basis points to 4.70%, marking the most substantial increase since 2009. Bloomberg reports that the iShares 20+ Year Treasury ETF (TLT) has lost approximately 48% of its value since its peak in 2020, with a decrease of over 13% in Q3 2023. In the last month alone, the TLT declined by 7.9%. Such price declines rival the epic corrections experienced in equity bear markets of the past, such as the 2008 Great Financial Crisis. These levels of volatility are generally unexpected in an asset class that is traditionally considered safe.
In the following sections, we will explore the reasons behind the poor performance of bonds and consider what we might expect in terms of bond yields moving forward.
The primary reason for the decline in bond prices is a subject of intense debate, but the leading theory revolves around speculation that the Federal Reserve intends to maintain higher interest rates for a more extended period. A secondary factor likely contributing to the situation is an oversupply of bonds. While the Federal Reserve decided to pause and refrain from increasing rates last month, they have not ruled out the possibility of future rate hikes. More significantly, they have indicated their expectation of only two rate cuts next year, in contrast to the four cuts they had previously guided for in June. Projections suggest that by the end of 2025, rates will be 50 basis points higher. The forthcoming easing cycle is anticipated to proceed at a more gradual pace. This approach may align with the Fed's aspiration for a gentle economic transition, but it deviates from the conventional course of action.
Recent analysis in a Wall Street Journal article has emphasized that when the Fed does reduce rates, they typically do so swiftly—a point not lost on financial markets. According to TD Securities, financial futures at the close of September consistently priced Fed fund rates considerably lower than the Fed's dot plots. While the Fed remains optimistic that they can achieve a smooth transition, financial markets harbour doubts.
Outlook for 10-year U.S. Treasury yields.
At the close of September, 10-year U.S. Treasury yields stood at 4.57%. Based solely on technical considerations, Strategas envisions a possible trajectory that could push rates beyond the 5% threshold. From a fundamental standpoint, Bloomberg recently highlighted that 10-year yields have historically peaked at the same level as the Federal Reserve's highest rate during its hiking cycles, which currently stands at 5.25% to 5.50%.
Interestingly, a recent Bloomberg survey revealed that while analysts have been revising their projections for 10-year yields upwards, the consensus still anticipates rates regressing to 4.06% by the end of the year. According to Strategas, not a single sell-side strategist is predicting that 10-year rates will exceed 5%, either by year-end or in the first quarter of 2024.
Factors influencing forecasted decline in 10-year rates.
Forecaster predictions of a decline in 10-year rates are heavily shaped by the belief that both inflation and economic growth are on a downward trajectory, and interest rates will soon follow suit. JP Morgan recently emphasized the strong correlation between the U.S. Manufacturing Purchasing Managers' Index (PMI) and 10-year rates, noting a notable divergence with PMIs experiencing a sharp decline.
Strategas conducted a similar analysis by overlaying the Atlanta Fed's GDP Trackers with the 10-year yield, revealing a scenario in which GDP has begun to trend lower while 10-year rates continue to rise. Historically, Deutsche Bank has pointed out that, on average, the 10-year yield typically starts to decrease after the last Federal Reserve interest rate hike, although the range of potential outcomes is quite wide. It is important to note that future rate declines should not be assumed to be orderly.
Strategas has drawn attention to the recent increase in 10-year rates, suggesting that it bears some resemblance to the breakout observed in 1987, which ultimately resulted in a sharp decline in rates during the Black Monday stock market crash.
Comparisons to the 1987 market crash and yield curve dynamics.
Drawing parallels to the 1987 market crash is particularly concerning, given that the recent upward movement in rates has primarily been limited to longer-term Treasuries, such as the 10-year, leading to a re-steepening of the yield curve. While it is typical for the yield curve to have a positive slope, the transition from an inverted yield curve back to a positively sloped yield curve is a challenging one for the markets to navigate and has historically coincided with recessions.
In a standard scenario, the yield curve steepens because short-term rates decrease, often due to the Federal Reserve implementing rate cuts. This phenomenon is referred to as a "bull steepener" because the steepening results from declining rates. As noted by Gavekal, a bull steepener typically occurs after the U.S. unemployment rate starts to rise.
On the other hand, a "bear steepener," where the yield curve steepens because long-term rates are increasing rather than short-term rates falling, is a rare occurrence, and it usually carries negative connotations. According to Strategas, the only two other instances of the yield curve steepening due to an increase in 10-year rates were in 1969 and 1973. In both cases, 10-year yields swiftly turned lower, and the economy subsequently entered a recession.
Impact of higher 10-year rates on financial conditions.
Higher 10-year rates can significantly disrupt financial markets, primarily due to their influence on financial conditions. According to Goldman Sachs, nominal 10-year yields contribute to more than 45% of Goldman's Financial Conditions Index (FCI). The other major component, accounting for just under 40%, comprises credit spreads, which, although still relatively restrained, have recently started to rise.
While nominal Fed Funds rates represent less than 5% of the FCI, their influence on the FCI is likely underestimated, given the impact that Fed Funds rates have on the other components, although this effect may have a lag. In any case, financial conditions have tightened, and this tightening is expected to pose an additional challenge for the economy in the future.
Balancing the impact on inflation and the risk of a recession.
The crucial questions facing the markets revolve around whether the tightening of financial conditions will be sufficient to curb inflation or if these conditions have already become excessively restrictive, potentially tipping the economy into a recession. These are pivotal inquiries, and there is a wealth of data that can be marshalled to support either side of the argument. Depending on one's perspective regarding the economic outlook, whether it appears bright or stormy, data is available to bolster these positions, sometimes even within the same economic release.
According to Bloomberg's monthly survey, forecasters still anticipate stronger economic growth in the short term and have reduced the odds of a recession to their lowest levels in a year. Notably, Bloomberg also highlights a recent surge in "soft landing" narratives, which has historically occurred before recessions, as optimism tends to peak just before downturns take hold. Interestingly, "hard" economic data, typically based on concrete economic indicators, has recently trended downward, while "soft" data, often derived from surveys, has shown an upward trajectory. According to Zero Hedge, this disparity could signify a gap between hope and reality in the current economic landscape.
The job market's role in shaping the economy's future.
The job market will be a pivotal factor in determining the future course of the economy, and thus far, it has demonstrated resilience. Job openings expanded in August, and September witnessed a significant surge in employment growth. Furthermore, July and August's numbers were revised upward. The Bureau of Labor Statistics (BLS) Establishment Survey reported a substantial increase of 336,000 jobs in September, marking the most significant gain since January. On the other hand, the BLS's Household Survey, used to calculate the unemployment rate (which remained unchanged at 3.8% in September), recorded a less impressive increase of 86,000 jobs.
Wage growth, however, did not demonstrate the same robustness. It slowed to +0.2% on a seasonally adjusted monthly basis, with an annual rate of +3.4% based on the past three months, marking the slowest pace since 2021. According to the St. Louis Fed, U.S. workers have been changing jobs less frequently, and the quit rate has regressed to pre-pandemic levels. This suggests that wage growth might have further room to decline in the future.
The Atlanta Fed's wage tracker also indicated that the pay increase U.S. workers received for switching jobs has mostly dissipated, signalling a relaxation in labour market tightness and a probable deceleration in wage growth. The contrasting signals are evident: job growth implies that the labour market remains tight, while wage growth and quit rates suggest that it is easing. Remarkably, a combination of low unemployment and softening wage growth is considered a "soft-landing nirvana."
Positive signs in recent inflation data.
In terms of inflation, recent data releases offer some encouraging trends. Core Personal Consumption Expenditures (PCE) inflation experienced a mere 0.1% increase in August, the smallest rise since 2020, with goods inflation essentially negligible. Additionally, consumer inflation expectations dropped to their lowest levels in over two years in early September. Both the Cleveland Fed's Trimmed Mean and the Atlanta Fed's Sticky Prices indices are on a notable decline, though they remain at relatively high levels. These developments indicate some respite in inflationary pressures.
Mixed perceptions on inflation.
Despite the data indicating a decrease in inflationary pressures, many consumers may not feel the same way. Prices for essential items, while perhaps not rising as rapidly, are still notably higher than pre-pandemic levels, leading to a continued sense of financial strain for many households. Furthermore, overall consumer inflation expectations vary depending on political affiliation. Republicans are more inclined to anticipate higher inflation over the next year and even the next five years, while Democrats tend to believe that inflation is more contained.
While the Federal Reserve has made headway in curbing prices, the work is not yet complete, and concerns persist about the possibility of another wave of price increases affecting consumers. According to a survey of 40 economists conducted by the Financial Times and Booth School of Business, a leading candidate for the next catalyst that could drive inflation higher over the next year is a restriction in the supply of oil. This factor underscores the need for continued vigilance in managing inflationary pressures.
Consumer financial resilience and excess savings.
Wage growth has played a crucial role in shielding consumers from the impact of inflation, but government aid and the resulting surplus savings have also contributed significantly. The question of when these accumulated savings will be depleted is a subject of intense debate. The Federal Reserve Bank of San Francisco recently estimated that the bottom 80% of households have already exhausted their savings, and the aggregate pool of excess savings is projected to be depleted by the end of the third quarter.
Revised government data, however, has increased savings estimates by hundreds of billions of dollars. This led Citigroup to raise the likelihood of a soft landing to 50%. Nevertheless, signs of consumer stress are becoming more apparent. The Federal Reserve Bank of New York reported that nearly 60% of households are experiencing greater difficulty in obtaining credit compared to the previous year. This is the highest level recorded since data collection began in 2013.
A recent Bloomberg MLIV Pulse survey suggested that U.S. consumers may be approaching a tipping point, with 77% believing that U.S. consumption on a quarterly basis will turn negative in early 2024 or even sooner. These indicators highlight the evolving and complex landscape of consumer financial resilience and its interplay with the broader economic context.
Implications of prolonged higher interest rates.
The potential impact of "higher for longer" interest rates on consumer spending and the broader economy is a topic of intense debate, not just among bond traders but across the financial markets. Over the past four decades, interest rates have been in a prolonged decline, and this period has been marked by historically low interest rates. Many investors have never experienced a market in which money wasn't essentially free.
The possibility of a recession could indeed cause rates to turn lower once again. However, a critical question is whether rates must continue to rise further to tighten financial conditions significantly and convince traders that inflation is truly under control and it's safe for rates to normalize. Real rates have already reached their highest levels since 2007, and even if nominal rates stabilize at this point, real rates will continue to increase if the trajectory of inflation continues to decline. Emphasizing the word "IF" is essential because the future path of inflation remains a subject of contentious debate.
As 10-year yields rise, there is a self-correcting or self-protecting mechanism ingrained in traders' minds. They understand that higher yields and the resulting tightening of financial conditions assist the Fed in its effort to slow economic growth and inflation. The higher 10-year yields climb, the sooner the market anticipates the Fed will cut rates. In this context, "higher for longer" can swiftly transition too "lower" very quickly. Furthermore, there are also unknown stresses that "higher for longer" rates are generating, which could culminate in a financial accident or crisis, a historical pattern that has typically unfolded when bond yields rise.
The Fed's potential policy shift and the role of bond vigilantes.
The prospects of lower inflation and a weakening job market could provide the Federal Reserve with the impetus to pause and eventually lower interest rates. When this occurs, or more likely, in anticipation of this move, bond yields should decrease. However, if they don't, blame could be placed on the so-called "bond vigilantes" who sell U.S. government Treasuries due to their belief that surging U.S. government debt levels will result in a flood of bond supply.
The U.S. Treasury issuance in the third quarter exceeded expectations, reaching $1 trillion, bringing year-to-date issuance to $1.76 trillion. This is the highest amount for any full year over the past decade, excluding the surge during the 2020 pandemic. The Congressional Budget Office forecasts the U.S. budget deficit for 2023 to be $1.5 trillion, accounting for approximately 5.8% of GDP. Alpine Macro estimates that the deficit has surged by $900 billion, or 3.4% of GDP, over the past 12 months.
While this level of deficit spending is not unprecedented, the uniqueness lies in the context. It occurs during a period of low unemployment and robust economic growth, conditions rarely seen during peacetime. According to Strategas, the U.S. has only run deficits exceeding 5% of GDP in 1982, 1992, and 2009, each time when the unemployment rate exceeded 7%. Currently, the unemployment rate stands at 3.8%. The current trajectory of U.S. government debt is deemed unsustainable, particularly given the prevailing interest rates. The Congressional Budget Office predicts the federal deficit will exceed $2.85 trillion and reach 6.1% of GDP by 2033, assuming interest rates decrease and no recession occurs. In simpler terms, it could be even higher.
However, Americans appear relatively unconcerned about this fiscal situation, with a recent Gallup poll indicating that only 2% of Americans consider the deficit or debt to be the most important problem facing the country. The discrepancy between fiscal realities and public perception adds another layer of complexity to this already intricate economic landscape.
Challenges and prospects for bipartisan fiscal solutions.
Addressing the United States' fiscal challenges and placing its finances on a sustainable path would undoubtedly require a bipartisan initiative that encompasses entitlement spending, such as Social Security and Medicare, as well as tax policy reform. While the solutions may be conceptually clear, the political hurdles appear insurmountable.
Recent political developments illustrate the challenges in pursuing bipartisan initiatives. For instance, in early October, Republican Speaker of the House Kevin McCarthy lost his position because he cooperated with Democrats to pass a short-term funding bill aimed at averting a government shutdown. This marked the first time in over 240 years of the House of Representatives' history that a Speaker was removed from their position. The Speaker failed to secure votes from any Democrats, which was expected, and faced opposition from eight members of his own party, ultimately ending his nine-month tenure.
In light of this situation, the Republicans must select a new Speaker and attempt to forge some consensus by mid-November to prevent another government shutdown. Recent data suggests that the rising risk of a government shutdown might be contributing to the uptick in yields. Amid this political turmoil, a Gallup poll indicated that 52% of Americans trust the Republicans in economic matters, representing a record high for the GOP since polling began in 1951. The Republicans might be gaining support from those concerned that the Biden Inflation Reduction Act is exacerbating inflation, but the threat of government shutdown does not bode well for the nation's economic well-being.
Given the existing political dysfunction and increased uncertainty, the prospects for a bipartisan deal to address America's debt problem are challenging. Overcoming these hurdles will require a significant shift in the political landscape and a shared commitment to addressing the nation's fiscal challenges, which is not guaranteed in the current political climate.
Drivers of rising yields and the uncertainty ahead.
The concern about increasing debt levels and their long-term impact on interest rates is a valid one, but it may not be the primary factor currently driving yields higher. The resilience of the U.S. economy and persistent inflation, which forces the Fed to maintain higher rates for an extended period, are likely the major driving forces behind the recent rise in rates. Concerns that demand for Treasuries will struggle to keep up with supply as the U.S. funding needs continue to expand also matter, especially in the long term, but these concerns are likely manageable in the short term.
We might be entering a higher-rate regime, but it's important to remember that a recession or financial crisis can still lead to falling rates. The challenge lies in determining when "higher for longer" rates will begin to have a substantial impact on the economy. Current data presents a mixed picture, with evidence pointing to both a resilient economy and a weakening job market, as well as a consumer who may be reaching exhaustion. Rates may continue to inch higher in the short term, but eventually, a recession or financial crisis could drive them lower.
An interesting development is the recent negative correlation between the stock market and positive economic news, meaning that strong economic data leads to declines in the S&P 500. This shift might be attributed to concerns about the potential damage that higher rates could inflict on future earnings as traders increasingly focus on this aspect. Historically, good economic news has been beneficial for stocks because it signifies strong earnings prospects.
According to Bernstein, the diversification benefit of blending stocks and bonds in a portfolio, which has been positive for the past two decades, has recently started to deteriorate. The rolling 10-year correlation between U.S. monthly equity and bond returns is now at zero. We may see this correlation turn negative again in the future, with bond gains helping to offset stock market declines if a recession or financial crisis prompts the Fed to cut rates. However, if this scenario doesn't materialize due to concerns over U.S. debt levels or persistent inflation, it could lead to a more dramatic decline in the price of risk assets. Investors need to keep a close eye on various pieces of the puzzle, but bond yields remain a top concern.
Disclaimer
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.
