When we started the year, the general consensus was that coming off 2022’s worst U.S. bond market in modern history, 2023 would see the fixed-income sector stabilize and rebound with solid returns. Through the first quarter, that is precisely what happened. However, as inflation proved more persistent, the Federal Reserve kept hiking the Fed Funds rate and fixed income assets sold off again. In September, the Federal Reserve made a somewhat surprising policy shift that will likely drive both stock and bond markets in the coming months.
What changed? Inflation has come down quite a bit since its peak but is still hovering about 1.5% above the Federal Reserve policy goal of 2.0%. Since March 2022, the Federal Reserve has attacked inflation by significantly raising the Fed Funds rate, which increases the return on short-term fixed income. We observed this directly with money markets and CD rates rising from less than 1% to their current 5% rates. Even the two-year Treasury rate eventually exceeded 5%. However, long-term rates stayed lower than short-term rates. There is an important reason. Long-term rates are typically driven by the market. If investors believe the Federal Reserve will successfully control inflation, the long-term rates may not increase as much. In September, the Federal Reserve announced they would likely hold off on future increases in the Fed Funds rate and let the bond market adjust for inflation. In short order, long-term rates jumped, and as a result, there were more significant short-term losses on fixed-income investments and 30-year mortgage rates rose to 8%.
The following chart captures a good part of this story by comparing the 10-year Treasury note with the 2-year note. Expected yields are higher for longer maturities. On July 5, 2022, the yield curve inverted due to aggressive Federal Reserve policy increasing the Federal Funds rate. Short-term rates have not risen much in the past month, but the 10-year Treasury hit 5% for the first time since 2007. The yield curve has flattened and may move to where long-term rates are higher than short-term rates.
2 Yr vs 10 Yr Treasury Note Yield Curve
Why is this so important to us? Normalizing the yield curve will likely lead to strong returns in fixed income. Also, it tends to boost stock market returns, at least in the short-term.
At the risk of being repetitious with respect to fixed income, we are working through the worst bond market in U.S. history. Rapidly increasing rates coming off of historically low-interest rates and Quantitative Easing (Fed purchasing bonds and holding them on their balance sheet) caused existing bond prices to fall. If you bought a 10-year Treasury bond in January 2021, you would have a loss of over 20%. The price of a 10-year bond has fallen over 12% since April. Although you will get 100% of your investment back when the bond matures, the interest rate is much lower. Lower-interest bonds lose value when you can purchase a new bond at a higher rate. Not only will holding current fixed-income investments yield higher income but there will be price appreciation on the bonds as they mature.
Another interesting example of this is in the chart below. Banks hold investments, including Treasuries. Remember Silicon Valley Bank? It was not the only bank with a balance sheet problem. Many banks would go under if they had to liquidate their fixed-income holdings today. This certainly increases the risk of investing in the banking sector should there be any kind of a run or forced liquidation of assets.
Held vs Available Securities
We continue to think bonds represent an opportunity, especially due to the anticipated normalization of the yield curve, and at some point soon will start to outperform shorter-term fixed-income vehicles.
If the bond market stabilizes like we think it will, it could help the stock market in the short term. The broad stock market has not done well since the end of 2021, with virtually all asset classes selling below their highs around that time. Although a handful of huge tech companies have dominated returns in 2023 after a very poor 2022, they have not brought the rest of the market along with them. We see opportunities in some sectors, such as semiconductors and industrials, driven by U.S. policy (and spending) as well as energy, particularly with global turmoil and the potential expansion of hostilities in the Middle East. Defense contractors and companies related to replenishing military supplies should also do well. Third-quarter earnings are starting to come and are generally above relatively modest expectations. We also see the possibility of a resurgence in commodity prices. The S&P 500 has had a rough couple of months, and we will be watching to see if it can rally off recent lows (which are close to levels of the sell-off in early October). We also included an updated commodities chart below. Whether or not inflation stays higher for longer may be directly related to whether we see another significant increase in commodity prices.
One final thought, as mentioned above, mortgage rates have hit 8%, a far cry from the historically low interest rates we saw in 2020/2021. There is certainly a pent-up demand for buying homes. If you fall into this category and have the cash flow to pay initial monthly mortgage payments, this may not be a bad time to buy a home because it is likely you will be able to refinance in the future.
SPY Chart Since September 2021
Commodities Index Chart
As always do not hesitate to contact us if you have any questions or concerns.