Interest Rates - Hard Stop
By Paul Morrone, CFP®, CPA/PFS, MSA
The fixed income market is the quiet, introverted sibling to the extroverted and limelight stealing equity markets (it’s also been said that bond markets are smarter than stock markets, but that’s a discussion for another time). Today, however, nothing is more front and center than interest rates and the bond market – specifically US treasuries and how the yields have changed during the most aggressive Fed tightening campaign ever. As we get closer to the end than the beginning, markets are hypersensitive to any headlines that could cause uncertainty as to the future path of the Fed as it continues its crusade against inflation. Monthly data points such as core inflation, consumer spending and labor market statistics have the power to move markets materially – which is exactly what we saw in the third quarter this year.
By most people’s definition, 2023 is still a ‘good’ year (at least as of the time of this writing US Large Cap equities, as measured by the S&P 500, are up about 12% YTD), but that number was better as of July 31st when the S&P was up about 19% and fell within 5% of the previous market highs reached on January 3, 2022. Then came the headlines – inflation unexpectedly rose, albeit only slightly, and the labor market showed to be more resilient than originally thought. Traders digest these facts in real time as they attempt to predict the Fed’s response to this new information during their upcoming meeting in November (where they are widely expected to initiate an additional 0.25% hike) – which is, in turn, essentially a bet against what is going to happen to treasury yields. Unfortunately, these are not the only factors at play, as the basic economics of supply and demand are also influencing treasury yields as the Fed continues to unwind its balance sheet, among other things.
Given the complexity of the matter, it’s not hard to see why Powell & Company continue to walk a tightrope in pursuit of the elusive ‘soft landing’ that they have been working towards. Raise rates too much and the economy gets choked into a recession, raise rates too little and inflation continues to spiral out of control. Further adding to the complexity of the Fed’s actions is the fact that the impact of decisions made today typically don’t reflect in the data for months in the future. Whatever your stance is with respect to the Fed’s actions, it would be naive to disagree with the fact that they are faced with the impossible task of predicting the future.
Back to treasuries for a minute. To better explain why treasury yields are so important, it’s best to understand some fundamentals of investment valuation before we go further. What is typically a very ‘boring’ asset class from a return perspective, treasuries serve arguably the most critical role in the entire investment universe. In addition to being the most liquid securities on earth, treasuries have the unique characteristic of being backed by the full faith and credit of the United States Government, which has never missed a principal or interest payment in its history. We’re not allowed to say that the principal and interest of these securities is guaranteed (because that’s a big no-no in my world), but it is all but assumed that the US government will continue to meet its obligations – no matter what.
Because of this, the valuation of virtually every security in the world is predicated on the yield of treasuries, the 10-year in particular. Investors are sensitive to this because they want to be compensated in the form of additional return above and beyond what they could get from a virtually risk-free asset (known as the risk premium). So, as the Fed continues to raise rates and liquidate its inventory of treasury bonds each month, the baseline rate rises (for the many reasons discussed above). When that happens, all risk assets get repriced in real time, which leads to volatility and price declines as investors pull money from risk assets in favor of safer ones. When treasury yields fall, conversely, risk assets become more attractive and there can be dramatic price increases as the lower yields are less attractive over the long term. The largest unknown, of course, is what yields will be at any given time.
What we do know is this – the fed is operating on a data driven path, evaluating the same data that the market sees and trying to make decisions now that they hope will produce the desired effects in the future. Each time data is released, we expect the market to react accordingly, meaning the headline risk and short-term volatility may remain elevated. Looking into the fourth quarter (with the exception of October), we have the benefit of seasonality where stock markets generally do well in November and December which may be a breath of fresh air for equity investors.
There is a plus side, however, to the current higher rate environment. Those with cash parked on the sidelines are starting to see interest being paid on their deposits. With short term CDs eclipsing 6%, its an attractive value proposition that has many savers (… not investors) scrambling to find the bank or credit union with the highest yield. In such an environment, many are wondering if it is in their best interest to abandon their long-term investment strategy in favor the safety and security offered by CDs. The answer, in most cases, is a resounding no.
While CDs, deposit accounts, and even fixed annuities are offering what seem like eye-popping interest rates, the key question of course, is how long the good times will last. No one knows for certain, but history shows that it is very unlikely that these elevated rates will persist for multiple years. Furthermore, should rates fall from the current elevated levels, that can provide a tailwind for virtually all major risk assets, with stocks and long-dated bonds being some of the largest beneficiaries of lower long-term interest rate expectations. We caution anyone considering making material changes to their long-term investment strategy to consider the big picture before making any rash decisions, especially as we are now closer to the end of this current ‘quantitative tightening’ cycle than the beginning.
Historically speaking, 2023 (and really the time period from October 2022 to now) has been relatively uneventful with markets continuing to rise and volatility settling down compared to the period immediately preceding that. Market retractions are normal, with 5% pullbacks occurring, on average, about 3 times per year, and pullbacks of 10% occurring once every 13 months. There hadn’t been any meaningful pullbacks for about 11 months, that is, of course, until September rolled around. One could argue that we were overdue for a reset and regression back to the mean. On our end, we continue to monitor risks and opportunities, of which there are a great deal of both, and maintain investment allocations designed to adapt to the rapidly changing investment climate.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All investing involves risk including the possible loss of principal. No strategy assures success or protects against loss.
The content is developed from sources believed to be providing accurate information.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
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