Bond yields rose in October, but this time in a much more mixed fashion. The two year Treasury yield increased by 20 basis points, while the thirty year bond rose by 39. The broad market as represented by the Barclays U.S. Intermediate Aggregate Bond Index had a total return of -0.80%, while the Barclays Municipal Bond Index returned -0.83%.
The bond market continues to be driven by expectations of Fed policy changes. On November 2, the FOMC announced its fourth consecutive rate hike of 75 basis points, bringing the Federal funds overnight rate to a range of 3.75% to 4%. Despite some evidence of either moderating inflation (from improved supply chain dynamics) or outright deflation (home price declines), not enough progress has been made, so we expect just a moderate downshift in the Fed’s pace: we expect a 50 basis point rate hike on December 14 and more to come in 2023.
With the unemployment rate at 3.5% and few signs that hiring trends have abated, the Fed has ample room to continue tightening. Indeed, job openings in September rose while recent ISM surveys also point to solid employment trends, all of which make slower wage gains less likely. Ultimately, we think the Fed will take Fed funds to a range of 4.75%-5% before potentially pausing to take stock of economic trends, and further hikes are certainly possible if inflation remains stubbornly persistent.
Those sectors most sensitive to interest rates, housing and autos, are showing signs of slowing in reaction to the significant change in yields. Prices for new and used cars as well as homes are beginning to decline and this should result in some reduced inflation pressure, but much more needs to happen for inflation to come down meaningfully. Given the global nature of the inflation problem and the lack of any clear path to peace in Ukraine, the risk of stopping too soon seems too high.
An article in the most recent edition of The Economist offers an interesting perspective on this topic. They examined a group of countries that had lowered official interest rates to all-time lows during the pandemic, similar to the U.S. but began raising rates sooner than the U.S. in order to avoid an inflation problem. Collectively, they have raised rates more aggressively than the Fed but inflation has yet to abate. At least part of the inflation problem for these and other foreign countries is the unrelenting strength of the dollar.
If there’s one factor that could sway Fed officials to begin signaling a slower pace of rate hikes, the strength of the dollar could be it. Against a basket of currencies, it is up about 16% this year and it’s starting to be a real problem for some of our important trade partners. Japan, for example, reportedly spent the equivalent of over $40B in recent weeks in an attempt to support the yen. Part of the dollar’s strength is a function of the Fed’s more aggressive rate hikes relative to the EU and Japan. With geopolitical turmoil causing immense strains, it’s plausible that tacit agreements may allow the dollar to weaken if other initiatives relating to Ukraine are supported.
With respect to the overall economy, areas beyond housing and autos are beginning to show signs of slowing growth or outright decline. So far there is little evidence that a recession is underway despite suggestions to the contrary. Third quarter GDP growth clocked in at 2.6% annualized, which is an improvement from the prior two quarters, but the pace of personal consumption (approximately 70% of the economy) slowed to 1.4%. A “core” measure of new orders — non-defense, ex-air — declined by 0.7%. Lastly, the ISM Manufacturing survey for September declined to 50.2, right on the cusp (below 50 indicates contraction, and above 50 indicates expansion). Other details within the GDP report also point to vulnerabilities that may push growth lower. The rebound in exports was driven by oil due to the war in Ukraine, but the strong dollar should begin curbing exports if only because many of our trade partners are in much worse shape due to the war, inflation, and other constraints.
In closing, it is increasingly clear that Fed rate hikes are having the desired effect of reducing demand which ultimately should reduce inflationary pressures, despite all the warnings earlier this year that Fed policy would prove ineffectual. Financial conditions have tightened and asset values are meaningfully lower, reducing the wealth effect for consumers even as inflation takes a toll. All of this diminishes the post-Covid bounce that many, including us, had expected. Ultimately, we expect these negative impulses will lead to a better “go-forward” scenario for economic growth, but there remains a bit of wood to chop as winter approaches.
Maple Capital Management, Inc. (MCM) is an independent SEC Registered Investment Advisor with offices in Montpelier, Vermont and Atlanta, Georgia.
This commentary reflects the views of MCM and should not be considered to be investment or financial advice. MCM does not warranty these views and will not update this communication after the date of publication. Any mention of specific securities is done for illustrative purposes and the securities mentioned may or may not be held in client accounts. No assumption or assurance should be taken that securities mentioned will be safe or profitable investments. Past performance is not indicative of future results
For further information, please contact Steven Killoran at 1-802-229-2838 or at [email protected] For further information about Maple Capital, including a copy of our informational brochure, please visit our website at www.maplecapital.com.
The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
The Bloomberg Intermediate US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market with less than 10 years to maturity. The securitized sector is wholly inluded. The index includes Treasuries, government-related and corporate securities, MBS, ABS and CMBS..
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.
The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
The Bloomberg US Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded.
The Bloomberg U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.