Fixed Income Market Update: Third Quarter 2023 (2024)

Mike Sanders, Head of Fixed Income, Portfolio Manager

• The third quarter saw the Federal Reserve maintaining its restrictive policy stance despite economic challenges, with interest rates continuing to rise. The Fed also signaled the likelihood of one more rate hike in 2023, with expectations of fewer rate cuts in 2024 and 2025.
• What is the neutral rate? The Fed and market do not seem to agree on the elusive interest rate fulcrum, which is leading to uncertainty and volatility in the bond market.
• The Fed's top priority remains inflation, though progress has been made, the desired 2% target remains distant. As the impact of Fed rate hikes unfolds, economic data will be closely scrutinized.
• Credit spreads have reflected optimism about a 'soft landing', with lower probability of recession benefiting risk-based market indicators, particularly high yield and BBB-rated corporate bonds; we remain skeptical.

After a volatile first half, fixed income investors began the third quarter firmly focused on fundamental data for clues about the future path of monetary policy. Not surprisingly, the Federal Reserve (Fed) stayed true to their word and reiterated that their restrictive policy stance would remain in place until significant headway is made lowering inflationary pressures. Interest rates continued their march higher as economic data releases remained surprisingly strong in the face of meaningfully higher mortgage rates, rising energy costs, and faltering consumer confidence. As we begin the final months of 2023, we are likely approaching the end of a historic, nearly two-year monetary tightening campaign. Yet, lower interest rates may still be some time away.

The Fed Remains on Engaged

During the third quarter the Fed met twice, in July and September, raising the Fed Funds Rate by 25 basis points (bps) at the July meeting and then pausing at the September meeting. This marks a change in the Fed’s policy normalization campaign, acknowledging that the final hikes may be at hand. Interestingly, both the formal policy statement and subsequent speeches stressed that additional hikes are possible and rate cuts remain a distant possibility, strongly reiterating the ‘higher for longer’ message. The Fed updated its summary of economic projections in September and, as expected, committee members indicated one more hike may be needed by year-end, which would put the Federal Funds Rate in a range between 5.50% to 5.75%.

More importantly, the Fed members indicated that fewer interest rate cuts will be needed in 2024 and 2025. The policy rate is expected to be 5.125% at the end of 2024 and 3.875% at the end of 2025, both 0.50% higher than the levels expected in June. This shift in expectations helped push intermediate and long bond yields higher as the quarter ended. During the quarter, the 2-year Treasury increased only 15 bps to 5.04%, while the 10-year and 30-year Treasuries increased by 73 and 84 bps, to 4.57% and 4.70%, respectfully. The significant move higher in interest rates moved total returns into negative territory with the with Bloomberg U.S. Treasury Index returning -3.06% for the quarter and now at -1.52% year-to-date.

Bond Yields Hinged Upon the Neutral Rate

Where bond yields end up relies heavily on the neutral rate, or the rate at which policy is neither restrictive nor stimulative for the economy. There has been a heightened level of uncertainty regarding what this rate is. The Fed’s internal projections imply a belief that the neutral rate is between 2.50% and 3.00%, though there seems to be indefinite uncertainty even among Fed members. The bond market has priced in a different, higher, level. Current market implied projections suggest a level above 3.50%. Some of the move higher in the implied neutral rate is due to an expectation of a soft landing, as we discussed earlier. This difference in expectations translates to a wide range of outcomes for the benchmark 10-year Treasury. If you assume a normal curve environment and risk premiums are near their long-term average, the 10-year could be 4%, or it could be closer to 6%, or higher. That uncertainty has stoked the volatility in bond markets, and we do not expect it to subside any time soon.

Looking Ahead: Focus Remains on Fundamentals

The Fed’s top priority remains inflation, and while progress has been achieved, the Fed’s desired target of 2% remains a distant goal. The latest reading on the Core U.S. Personal Consumption Expenditure Pricing Index fell to 3.9%, slightly lower than the last reading of 4.3%. Clearly, some progress has been made on the inflation front, but not enough to satisfy Fed members. The U.S. economy has remained surprisingly strong despite higher interest rates, rising energy prices, and falling consumer savings rates. Stable labor markets and resilient consumers give the Fed additional runway to maintain restrictive monetary policy while battling inflation pressures. A clear risk to the Fed’s policy outlook would be sharp declines in economic growth while inflation pressures persist. Resultingly, economic data will remain scrutinized as the lagged impact of Fed rate hikes work through the system. While we are skeptical of the Fed’s ability to navigate a ‘soft landing’, we do expect growth to gradually decline as consumers feel the impact of higher interest rates and price levels.

Credit Spreads Reflect ‘Soft Landing’

As investors embrace the possibility of an economic ‘soft landing’, risk-based market indicators, including credit spreads, have performed well. A lower probability of a recession translates to reduced corporate bond credit spreads. Lower quality sectors such as high yield and BBB-rated corporate bonds have performed the best relative to Treasuries so far this year. The Bloomberg U.S. High Yield Bond Index has returned 5.86% year-to-date, surpassing similar maturity Treasuries by 5.16%. The Bloomberg U.S. Credit Baa-rated Index has returned 0.56% year-to-date, surpassing similar maturity Treasuries by 2.84%. In comparison, the Bloomberg U.S. Credit A-rated Index has returned -0.43% year-to-date, surpassing similar maturity Treasuries only by 1.92%.

Outlook

We remain skeptical of the market’s recent embrace of a likely economic ‘soft landing’. Clearly, we are closer to the end of rate hikes than the beginning, but the Fed’s ability to successfully tame inflation without tipping the economy into a recession seems unlikely. Elevated interest rates are impacting rate sensitive sectors of the economy and with each passing month, inflation cuts further into consumer budgets. Rising interest rates have provided fixed income investors with opportunities to take advantage of yield levels not seen for many years and we have taken advantage wherever possible by extending durations and adding to portfolio holdings. We expect elevated yields and market volatility to persist as markets focus on fundamental data for monetary policy implications. That said, there is still a good chance for positive returns at year-end in short to intermediate bond portfolios. And, with where yields are today and where they could potentially begin 2024, the outlook for mid to high single-digit returns next year hasn’t been this strong in 15 years. Current yield levels not only adequately compensate investors but also reaffirm the significance of including fixed income exposure in an asset allocation strategy.

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