Year in Review
In reviewing 2023, the key takeaway is that it was yet another year where the consensus outlook failed to materialize. There was no recession and no equity market crash. Even the Federal Open Market Committee (FOMC) was forecasting a recession with their view that unemployment would end 2023 at 4.4% to 4.7%. This is the first time this has happened since forward guidance was introduced and a glaring signal that recession probabilities were too high. It would only take a few cracks in this consensus view to push up bond yields and stock prices as the year unfolded.
The market expected the Federal Funds Rate to end 2023 at 4.5%, whereas the Fed was at 5.25%. The market was wrong versus the academics for the second consecutive year as the Fed Funds ended at 5.5%. The bond market’s reputation has lost some of its luster in recent years.
The December FOMC meeting ignited a huge rally in almost all asset classes. The consensus was that Fed Chair, Jerome Powell, would push back against the bond market’s anticipated two rate cuts in 2024. Instead, the Fed Chair was dovish as they noted that rate cuts were beginning to be discussed. The Fed came in with an expectation of three cuts in 2024. The bond market quickly priced in six as two-year Treasury yields dropped 31 basis points on the day. The FOMC is expecting a year-end Fed Funds Rate of 4.75%, whereas the bond market is between 3.75% and 4.0%.
Core fixed income returns were poised for their third straight losing year, which would be unprecedented in the last 100 years. Returns were down 3.4% in mid-October before staging a nearly 8% rally in less than two months. The last rate hike was in July and “pause” became the buzz word. By mid-October it was clear there would be no hike for a second consecutive FOMC meeting, thereby transitioning to the idea the last hike was in. Bonds rallied yet again when the idea of cuts was surfaced at the December FOMC meeting.
No Time for a Victory Lap
Jerome Powell noted in July the Fed would be cutting before inflation reached 2%. He acknowledges at every FOMC press conference that current policy is quite restrictive. The market always treats this as hawkish, but it is dovish in the sense he is admitting they have room to cut rates without causing inflation to rise. This is why risk assets continue to go up and bond yields have been moving lower in recent months to the dismay of many market commentators. The above theory was proven correct because as soon as rate cuts became the base case for the FOMC, bond yields moved lower yet again.
The bond market has now priced in the expectation that rate cuts could begin as early as March with a cut at nearly every meeting to follow. We finally have everyone jumping to the other side of the boat. More are favoring a recession in 2024 now that yields have made a big move lower. Others think politics are the reason for the pivot in December. Either way, we think the bond market will likely be wrong for the third straight year.
We lean to more favorable economic outcomes in 2024. With stocks approaching all-time highs, there isn’t an immediate need to shed labor and it is likely labor hoarding will persist as long as stock prices remain elevated. Jobless claims remain at rock bottom levels, the unemployment rate is under 4%, real wages are moving into positive territory, gas prices are down, and the deficit is over 6% of GDP. These are favorable measures for consumer activity, but on top of this we have lending rates moving down off their highs which will transmit into the real economy quickly. The cherry on top is the wealth effect, which has likely morphed into becoming the main component to future growth and inflation given how high financial assets are relative to GDP.
Financial conditions since the end of October have fallen at the fastest pace in at least 40 years, outside the Global Financial Crisis and the pandemic of 2020. This is a huge boost to growth and inflation prospects as consumers feel wealthier to go along with solid job prospects. We think the seeds are sown for a reacceleration of inflation to uncomfortable levels in the back half of 2024 and especially into 2025. The timing will be key as inflation will lag for most of the first half of the year.
Growth is clearly decelerating, so bond yields have little resistance in moving lower for now. We do think sometime in the first half of 2024, the market will sniff out a reacceleration of growth and inflation and price out back-end cuts and restart the idea of hikes. We anticipate bond yields will bottom in the first half of the year and potentially move materially higher in the second half.
Corporate bonds may be vulnerable to underperformance in the second half, but we don’t envision sharp losses as investors have a good experience with buying higher yielding safe assets. Investment grade corporate bonds were up about 8% in 2023. Mortgage-Backed Securities are very cheap and should outperform as soon as the yield curve begins to steepen.
Sources: BTC Capital Management
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