While hard economic data has been coming in soft, both equity returns and fixed income spread product have responded favorably. (UBS)

The combination of two forces—price appreciation due to declining interest rates and spread compression as the market anticipates the end to a historic Fed tightening cycle—resulted in the Barclays Aggregate bond index producing a return of 4.7%, its best one-month performance since October 1987; the high yield (HY) index 4.6%, the highest since July 2022; and the investment grade (IG) corporate index 5.6%, its best since December 2008.


And while preferred securities’ 10.4% total return may only take it back as being the best since January this year, it leads all other fixed income assets for the month of November. Even agency MBS, which has faced technical headwinds since the financial instability episode in March, gave its best one-month absolute return since May 1985, up over 5%, while municipals returned its sixth-best month on record at 6.35%.


Finding the holiday cheer

Interest rate volatility collapsed in November as the 10-year Treasury yield moved 76 basis points lower from the year-to-date high of 5.01% reached in October. While the core PCE inflation rate moved down to 3.5%, the lowest since April 2022 and pushing the 10-year breakeven inflation rate to a five-month low, the current real yields for both the 5- and 10-year still trended lower, down nearly 60bps and 40bps, respectively, from the October highs. While 5-year real yields are currently at 2.01%—below our 2.25% assumption when we made our 5-year TIPS allocation—we maintain our TIPS preference as current inflation expectations remain suppressed. While the WTI oil price was down 6% in November, assisting in the decline in short-end inflation expectations, we believe inflation may remain higher than what is currently priced, favoring the TIPS market.


The bad and good

While hard economic data has been coming in soft, both equity returns and fixed income spread product have responded favorably. The “bad news is good news” data, flow has led the market to cement not only the outlook that the Federal Reserve will pause from rate hikes at its 13 December meeting, but also the thinking that the Fed’s move from pause to pivot will be earlier and greater. Currently, the market is pricing 138bps of interest rate cuts in 2024, with a 15% chance of the pivot starting in January and 100% in May. This, combined with an additional 55bps of easing in 2025, brought the market’s expectation of the long-term federal funds rate to 3.4%, a full 100bps lower than what was priced in during the peak rates of October. As we discuss below, this is far too optimistic in our view.


Interest rate volatility has collapsed as the market removed the possibility of witnessing one tail risk to end 2023—a Fed hike—as the updated Atlanta GDPNow forecast for 4Q23 has slipped to 1.2%, after trending at 2% last week. The VIX volatility index fell to 12, its largest absolute monthly decline since November 2022.


The decline in volatility has compressed fixed income spread product across the board. Spreads on high yield (HY) bonds and preferred securities compressed over 60bps on the month, both testing their year-to-date lows. While 10-year yields remain 80bps higher than the start of year, the higher yields investors are earning in fixed income are due to interest rates, not the risk premium. While we remain positive on the sector, we think total return in the year ahead will be generated from yield and price appreciation as the 10-year Treasury yield trends toward 3.5% by 4Q24, not due to material spread compression in fixed income. As a result, higher-quality and higher embedded interest rate sectors should lead the way in 2024.


But not quite yet

While over the longer term we look for yields to trend lower as growth and inflation abate in 2024, currently we think the market is pricing in a much too dovish Fed. With 138bps of easing priced for 2024, 10-year yields have moved materially lower as the term premium is once near negative territory. While the October narrative was led by higher Treasury supply, quantitative tightening, and the need for investors to be compensated for taking on incremental interest rate risk, softer data and the outlook for a dovish Fed have shifted the narrative. While we believe the move to 5.01% in October was an overshoot and that the upcoming Treasury supply will play second to economic growth as a factor, the large move over the month needs to be met with a bit of caution.


In our view, the 10-year yield will likely end 2023 in a 4–4.5% range; however, it is too early to assume the 13 December FOMC meeting will be a dovish pause rather than a hawkish one as financial conditions continue to loosen. We therefore believe the 10-year yield may trend higher into the first quarter of 2024, despite our view that the longer-term trend is lower.


The market pricing’s in of excessive Fed easing is a script we witnessed during the summer months, only to result in a large reversal. While the passage of time has allowed for more economic data, leading to lower inflation and growth, we continue to view the 5.01% yield level as the cycle high. However, the Fed will likely pause for longer before reversing course, and the market perception of the future fed funds rate remains aggressive. We look for 50– 75bps of easing starting at the end of the third quarter until the data warrants otherwise.


Main contributors: Leslie Falconio, John Murtagh


See the original blog, Santa pause , 4 December, 2023.