Interest Rates Jump
Interest rate volatility spikes again as we begin the fourth quarter with the MOVE Index jumping up above 140. This measure of bond volatility has persisted above 100 for about 18 months. In the last 30 years, this only occurred during the Global Financial Crisis.
- The 10-Year Treasury yield moved 67 basis points higher in the third quarter. And then jumped another 22 basis points in the first two trading days of the fourth quarter.
- 2-year Treasury yields only up 15 basis points as the curve steepened.
- The 30-year Treasury bond issued in May of 2020 is down 55%, which is now equivalent to the drop in the S&P 500 during the Global Financial Crisis.
Global sovereign yields have moved materially higher throughout the year even as manufacturing growth has slowed. Japan has hinted at potential changes to their yield curve control policy. They used to be willing to buy unlimited amounts of bonds at 25 basis points. This resulted in the most extreme central bank policy intervention in the world. The Bank of Japan’s balance sheet as a percentage of GDP is 130% compared to the United States peak level of 37% during quantitative easing. They have since widened the band and the market continues to push up their yields.
- The German 10-year bond traded as low as -71 basis points in 2020 and is just shy of 3% today.
- The famed Austrian century bond issued in 2017 gained more than 130% as 100-year yields went from 2% to 0.4%.
- The subsequent move from 0.4% to 3.6% has seen the price fall 75%, resulting in a current loss of 40%.
U.S. investment grade spreads were relatively unchanged during the quarter, which resulted in a positive excess return. Year-to-date, the corporate bond index has a return of -1.6% whereas the Treasury Index has lost 2.6%. It was better to own corporate bonds versus Treasuries. Mortgage-backed securities are down 3.9%, thereby resulting in the total core bond index return of -2.7% through three quarters.
The Fed Pauses
The Federal Reserve (Fed) raised interest rates 25 points in July and then left them unchanged at 5.5% during their September meeting. The Fed dot plot indicated another potential hike this year, but Chair Powell’s testimony included some phrases that would question whether another hike is likely. The Fed did bring up their estimates for the Federal Funds Rate in 2024, thereby solidifying their higher for longer expectations.
The market is pricing just under a 50% chance of another hike this year. It is then anticipating 2.5 cuts in 2024. The spread between 2-year Treasuries and 30-year Treasuries has increased by 50 basis points in just 10 days since the Federal Open Market Committee meeting. In this time span, we got two jobless claims reports that showed a notable drop. Longer dated bonds appear to be mispriced if indeed the Fed engineers a soft landing or no recession. The last soft landing was in 1994 where 10-year Treasuries went from 5.2% to 8.0% in a year. The S&P 500 sold off 9% and then stabilized before continuing its secular bull market.
The portfolios are currently near benchmark on duration. While the trend is currently toward higher yields, there appears to be sufficient growth risks to warrant a more neutral outlook. Despite yields moving up materially in recent weeks, the dollar has remained strong, and suggests confidence in the U.S. system remains sound relative to the rest of the world. Our outlook on corporate bonds remains tilted slightly to the bullish side for the final quarter of the year.
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