Dear clients and friends,
October marked the third straight monthly drop for U.S. stocks where the Nasdaq and S&P 500 entered correction territory (down more than 10% from the most recent 52-week high). We mentioned last month that these corrections happen about every 16 months on average so this was not terribly unexpected. What is more of note is the volatility that has picked up in the bond markets as of late. This writing will attempt to unpack what is happening here (without getting too technical) because it is in the driver seat for many of the markets we participate in (stock, real estate, and fixed income).
While the recent volatility (caused primarily by interest rate increases) may seem as though the bond market is coming unhinged, we believe much of the rate volatility can be tied back to current economic data and the markets perception that a “soft landing” is imminent. Generally speaking, a soft landing means the U.S. is able to achieve a mild recession where GDP slows (but not significantly) while employment remains strong and inflation continues to fall. This is the best case scenario and relatively unheard of historically when we have prolonged yield curve inversion and aggressive rate hikes by central banks.
Conversely, if the market believes a soft landing is on the horizon, it also suggests the potential for stronger economic growth with higher inflation for a longer period of time, resulting in higher interest rates for a longer period of time. So instead of ripping off the recession band-aid where unemployment spikes and inflation gets wiped out quickly as a result, we limp along for a period of time and draw out of the process in a prolonged manner (sometimes referred to as a rolling recession). This is one reason why bond rates have been increasing without further hikes on the short end of the curve by the Fed. The chart below shows the current Federal Funds Rate futures where market participants bet on the direction of the Fed.
This chart shows the market believing the Fed might leak one more rate hike towards the end of the year or early next, but by and large they are done and will start cutting rates marginally towards the end of Q1 2024. Even though we believe the Fed won’t start cutting rates until later next year, we do agree this is the most likely trajectory from here and it’s one of the main reasons we have so much optimism for our bond holdings in spite of the doom and gloom in the news. As many of you know we started buying bond positions back in March after a long hiatus of eliminated them from the portfolios in 2020, 2021, and 2022. This decision was made because of the asymmetric return profile at the time that has only been magnified by bond rate increases in the intermediate and long-end of the curve over the last 2 months.
This chart shows as of 10/20/2023 how different length treasury bonds would perform given a rate increase of 1% OR a rate decrease of -1%. You can see on the short end of the curve (2 and 5 year treasuries) that even if rates go higher by 1%, they will still have a positive total return assuming they are sold 12 months after purchase. Toward the intermediate and long-end of the curve (10 and 30 year), there would be a negative total return under the same conditions. But the risk/return profile becomes asymmetric when looking at these conditions if rates decrease by -1%. You can see here that total returns would be very positive across the entire yield curve, and magnified along the intermediate (+10%) and long end of the curve (+20%).
The majority of our bond holdings live in the intermediate, high-quality, corporate space where we believe there is the least amount of risk for the greatest return potential. Now you might be wondering why we don’t keep our bond holdings purely on the short side of the curve, and here is why. The data below outlines the opportunity cost of keeping funds too heavily weighted on the short end of the curve (or money market) by showing the returns over the last 7 monetary tightening cycles after the Fed pauses rate hikes.
One additional thing to mention here is if the market is wrong about a soft landing and instead a deeper recession occurs, then the return profile gets even stronger as rates would fall more than 1% and these return figures would be much higher from what is shown in the asymmetric risk/return chart. The rule of thumb would be to double the numbers above for an additional 1% drop in rates.
If that scenario starts to play out, look for us to make some adjustments where we move our bond allocation further out on the yield curve to take advantage of this dynamic.
All the best,