The Beatings Will Continue Until Morale Improves (or, Higher for Longer)
Over the course of the third quarter of 2023, some progress was made in the Fed’s efforts to dampen inflationary expectations, however areas of inflation remained stubborn. Energy prices rose and people felt increasing pain each time they visited the gas station. Between food, fuel, and housing, inflation continued to apply pressure to consumers and measures of consumer sentiment. In response to the areas of continued price pressures, the Fed repeated their current mantra of “Higher for Longer.” In the most recently released Fed “Dot Plot,” the Fed signaled that one more rate hike is possible this year and roughly half the cuts to rates are now anticipated in 2024 (50 basis points of cuts are expected next year). The market anticipates approximately a 25% chance of a hike in November of this year or January of 2024 and that by the end of 2024 they may need to cut rates by approximately 50 basis points.
Dysfunctional politics didn’t experience a metamorphosis into something more perfect. Congress passed a continuing resolution to table the debt ceiling crisis, followed by removing the Speaker of the House from his position. Shutting down the government seems to rarely provide meaningful solutions to many of the big problems we face as a nation. We will have the opportunity to revisit the bluster, political sausage-making and worthless outcomes ahead of the Thanksgiving holiday. The discretionary part of the Federal budget only represents a small portion of the Federal budget (roughly 25% of the Federal budget, 15% if you exclude defense spending), so in the longer-term some more substantive changes may be needed to save some of the programs that are political third rail topics. In the meantime, our representatives will play around the middle with threatened spending cuts, tax cut expirations, and tax increases. If possible, a thoughtful review of changes to entitlement programs may be needed to equitably save the very programs that are currently untouchable. The current state of politics in the U.S. isn’t doing anything to further the economic prosperity and confidence of the constituents our representatives serve. In early August, the culmination of our political and fiscal choices resulted in a downgrade of U.S. creditworthiness from AAA to AA+. The change represents the second of the three major credit rating agencies to downgrade the U.S.
"...2022 represented the third consecutive year in a row that on a real (inflation-adjusted) basis, households saw incomes fall."
The sustained impact of tight Fed policy, marginally offset by a glacial pace in the reduction of fiscal stimulus, has resulted in a deceleration in some growth metrics and broad measures of inflation. Although some unavoidable areas of household expenses, such as food, energy, and shelter, have remained naggingly punitive for the average household, other areas of costs are seeing improvement in terms of slowing growth rates. One could argue that housing price pressures are decreasing (slightly, and in certain markets) but with 30-year mortgage rates at 7.88% (as of October 9th per Bankrate.com), home affordability is out of reach for most first-time buyers. On an inflation-adjusted basis, 80% of households have spent their pandemic era savings accumulation and default rates on both auto loans and credit card debt are returning at levels not seen since 2011, when the economy was recovering from the Great Financial Crisis (GFC). Of note, the amount of auto loans ($1.5 Trillion) is nearly twice the amount outstanding during the GFC and credit card debt ($1 Trillion) is nearly 50% higher than was the case during the GFC. Total household debt in the U.S. reached a record level of $17.06 Trillion in the second quarter of 2023 (Source: New York Federal Reserve). According to data released in September by the U.S. Census Bureau, 2022 represented the third consecutive year in a row that on a real (inflation-adjusted) basis, households saw incomes fall. 2023 has seen some months with modest real wage growth, but the main point is that households have been falling behind, prices of the most frequently purchased, unavoidable, and most significant household budget items remain painfully expensive. If not for the 3.8% unemployment rate and the shockingly strong job market, the frequent market debate between a soft economic landing and the “no landing” scenario would be mere wishful thinking.
Continued job market strength, sticky sources of inflation and a Fed that is expected to keep yields higher for longer, have resulted in higher bond yields and fixed-income investor losses. 10-Year Treasury yields started the third quarter at 3.84% and ended up at 4.57%. 10-Year AAA-quality municipal bond yields began the quarter at 2.54% and ended at roughly 3.44%. Through the end of the third quarter, the most broadly watched taxable bond indexes experienced losses of between -0.3% and -1.20% on a year-to-date basis, while many municipal indexes experienced losses for the year of -1.50% to -3.70%.
Observations and Outlook – Beware the Jump Scare
Many people have a love-hate relationship with the jack-in-the-box (the children’s toy, perhaps the restaurant too). You know at some point in the melody the spring-powered, often ragged clown pops out of the box and scares you. The evolution of the Fed’s “higher for longer” mantra may be best dissected into two parts. The “higher” part is likely near the peak. If it isn’t, Fed credibility will be at risk because it will mean another major policy blunder and misreading of the economy. What probably remains is the “longer” part of the mantra. Against the reality of stretched consumers, evaporated savings, more debt that is more expensive to service, household budget pressures, and deteriorating sentiment, it feels like the “longer” part of the Fed’s strategy is the music that leads up to the clown springing out of the box. Higher rates and their restrictive power are impacting consumers, financial institutions, levered corporations, and it is even calling into question the sustainability of government spending. As indicated earlier in the year, people seem to be anticipating something to break because of higher borrowing costs. It may be the case that corporate spreads crack, or a general availability of credit is frozen, but the most likely “thing” to break is confidence. At a point, suspension of disbelief will be met with reality and the crisis of confidence often occurs with a crescendo of fear.
Although recent employment reports have been robust, a reversal of the strength of the job market would remove the pillar of support that has helped to sustain the pace of consumerism since 2020, the idea that anyone who cared to work could find a job. We have discussed The Sham Rule in the past, which is a timelier indicator of the start of a recession. It is triggered when the three-month moving average of the unemployment rate rises by 0.50 percentage points relative to the low during the previous year. If unemployment increases above 4%, it is likely we will have crossed the recessionary threshold, and that the assuredness of job seekers may turn to diminished confidence. Although it seems like the momentum of the employment environment will carry us through the end of the year, a few statistics suggest a cooling of some areas of the job market. September average hourly earnings rose 4.2% on an annual basis, the smallest gain since June of 2021. The Quits Rate, held at 2.3%, the lowest level since 2020 and the ratio of job openings to unemployed people was 1.5 times, down from the 2022 peak of 2.0 times. In all, it suggests some early signs of waffling as it relates to confidence in the job market.
"The Fed has brought a lot of firepower to this skirmish with inflation."
Increasingly, Fed officials are suggesting that the market, in the form of a flattening yield curve, caused by longer-term yields rising, may be doing some of the Fed’s inflation fighting for them. The recent surge in yields has caused alarm for both the mortgage industry and homebuilders, and pretty much any large ticket items that are often financed should experience a challenging environment. Atlanta Fed President Raphael Bostic said at an American Bankers Association meeting that he doesn’t think policymakers need to raise interest rates any further and that policy is restrictive enough to bring inflation back to their 2% goal. Other recent Fed official comments have speculated that the movement of long-term yields is approximately the equivalent of an additional two rate hikes. At the time of the writing of this piece, the market expectation for an additional hike has fallen to 26%. Whether there are no hikes, one hike, or even a couple of hikes, the heavy lifting by the Fed has been done with the previous 500 basis points of tightening over the past year and a half, to the highest Fed Funds Rate in 22 years, compounded by the Fed’s Quantitative Tightening efforts (where they are letting their Treasury portfolio pay down and mature). The Fed has brought a lot of firepower to this skirmish with inflation.
The increase in long-term yields has brought the “real yield” (the nominal yield on bonds minus inflation) to approximately 2%. The higher real yields go, the more restrictive it is for economic growth. It is “bad” for some consumers and “good” for savers. For context, real yields were negative 1% during the pandemic, and for the past 15 years they have averaged around 1%. For a very long-term perspective, since 1959, real yields have averaged roughly 3%. More recently, during the GFC, real yields spiked to 3% and to burst the internet bubble the Fed took real yields all the way to 4%. Real yields can increase by nominal bond yields increasing relative to inflation, or they can increase due to falling inflation expectations. As the Fed continues pursuing the path of higher for longer, real yields may climb due to falling inflation numbers. Alternatively, if the economy remains robust, the economic restraint may come in the form of higher yields. If interest-sensitive sectors don’t slow and if employment holds up, momentum along with other structural reasons for higher yields may carry 10-year Treasury yields north of 5% (this assumes the attacks in the Middle East don’t escalate into another “hot” war, or potentially worse yet a regional conflict, which would create demand for U.S. Treasuries as a safe haven asset).
Although higher rates and increased real rates may offer confusing market signals, there are some structural reasons why interest rates may trend upward. After all the fun theoretical discussions about the wonders of Modern Monetary Theory, it seems that even if a country taxes, spends, and borrows in a fiat currency they may eventually be constrained by revenues as it relates to federal government spending. Once the ability to deficit spend is abused, unless the central bank funds the Treasury in near perpetuity, a natural buyer at a neutral rate (r*) must be found for the debt. The difficult part of the transition from the Fed’s Quantitative Easing (QE) plan to the current QT environment may be that a lot of borrowers who became highly indebted at nearly “free” rates, will have their funding reprice at higher rates. Now the market is trying to establish clearing rates at the same time the world’s largest balance sheet (the Fed) is on the sidelines. It could mean that rates will be higher than those to which we’ve become accustomed. Higher rates might not work for a large swath of “junk” rated borrowers and the large number of companies that are not profitable (and that was before the cost of financing increased). Although there are still stimulus dollars floating around in the economy, combined with significant deficit spending, the fact that nominal and real rates have risen to the current point without devastating the economy suggests that neutral rates might be higher than previously thought.
"The easy choices of the past will require hard decisions and hard times."
The more headline-worthy structural reason for higher rates is the deteriorating fiscal health of the U.S. government. Since the Fitch downgrade of U.S. creditworthiness, which was largely scoffed at by some of the largest names in the investment industry, as well as the Secretary of the Treasury and other government officials, the market seems to have decided that it may be a worthwhile topic for contemplation and discussion. With a growing economy and 3.8% unemployment, the estimate from the non-partisan Congressional Budget Office for the U.S. federal deficit in 2023 is $1,700,000,000,000 ($1.7 Trillion). Given the gridlock in Washington, that isn’t likely to improve anytime soon. Worse yet, what if unchecked power resumes, what might that feel good deficit look like then? The growing federal debt and the rising interest rates required to find buyers for the debt mean we will simply be allocating resources to pay our interest costs. The annualized interest cost to finance the debt is nearing $1 Trillion. That is more than the cost of Medicare and it’s close to the annual cost of Social Security. Dissecting longer Treasury bond yields into basic parts, the neutral short-term interest rate (r*) plus the rate of inflation, added to the “term premium” which is the additional yield investors require for the risks of long-term lending gives you a model for understanding the components of yield. All the variables move around during different market states. Larger deficits likely push both r* and the term premium higher due to the increased supply of debt that needs to clear the market as well as the increased uncertainty of the future of the borrower. The crisis of the pandemic is long past and the current year’s deficit is expected to be 6% of GDP, a level not seen in the six decades between the last World War and the GFC. Current and past malinvestment will require a discussion about tax policy and spending capacity. The easy choices of the past will require hard decisions and hard times. Punitive tax rates will impact productivity and growth, the engines of broad prosperity (capital goes to where it is treated best). Devastating cuts to intelligent social spending jeopardize upward mobility, it may reintroduce social unrest and result in a broadly diminished quality of life.
Objectively, Fitch was right to downgrade the U.S. debt. Political polarization, structurally hard-wired debt ceiling “games of chicken,” past misuse of resources, violations of contracts between the generations, the evolving recession of character, and crippling debt and deficits make the future paths less sound than the past. It may accelerate the decline in U.S. influence in global affairs (an imperfect record but better than most), as increasingly we choose between helping needy people at home and other people somewhere else. Deglobalization and the change to multipolar world order may result in more regional conflicts that could spillover into something larger. An economically hamstrung U.S. likely results in less peace rather than more. Back to the numbers that support Fitch’s decision. Bloomberg Intelligence estimates that mandatory spending on Medicare and Social Security will keep the federal deficit at around 4% to 5% of GDP and that slower growth and higher borrowing costs will take the debt to GDP up to 145% by 2028. Shockingly, their estimate is that by 2040 the number could reach 185% to 195% of GDP. At a point, likely not too far from 200% of GDP, the percent that debt service costs absorbs of the economic production of the country is so great, you can’t raise taxes enough or cut spending enough to avoid insolvency. Fitch’s forecast is that U.S. debt to GDP will reach 118% by 2025, roughly three times higher than the median of 39% among countries they award the top AAA rating. It seems that the political landscape and social realities will address the next challenge with more stimulus, until the math and the markets dictate austerity as our future path.
The base effects we’ve discussed in the past may give an indication that growth is poised for positive surprises in October and November but as December through February of next year unfolds, it may have the opposite effect (about the same time as consumers runs out of gas and holiday spending turns into credit card balances). 2024 may offer bond investors a good chance for of a bit of relief. After two consecutive years of negative returns, the likelihood of a third seems remote. It seems like a rolling recession that expands to a general crisis of confidence is a likely scenario. Housing investment, areas of commercial real estate and heavily financed purchases such as autos sound like they are feeling the pain now. Levered companies with repricing debt and a general chill in the credit markets seems like a logical next step. Job losses and a collapse in consumer confidence could be close behind. Bonds could see strong returns in 2024, and as many institutions and individuals we serve are simply tired of seeing portfolio value losses, we anticipate some relief. The real question is what the response will be to the next downturn. Stimulus checks? Money being thrown out of helicopters? Will we have finally instituted the digital dollar and stimulus funds can be deposited conveniently into your account (from someone else’s account)? It is the response to the next challenging moment that may turn short-term relief into longer-term pain. At the start of October, CNBC commentator Rick Santelli, citing the debt, deficit and the bond vigilantes predicted that should certain conditions be met, we could see a 13% trend over the next ten years (in the 10-year Treasury). If the bond vigilantes bring order to our fiscal house, rather than some proactive steps, the pain of scarcity may be widely felt.
Municipal Market Developments – New Strains Emerge
Last quarter we called for a bout of indigestion for bonds as signs of growth and persistent inflation drove yields higher. The move caused most bond sectors to show losses for the year, and munis were no exception. Our expectation that municipal investors would experience coupon-like returns will likely be a miss for the year, but we expect that December offers some hope for recovery. As mentioned earlier, after two consecutive years of poor returns for bonds, with the pressure mounting on the consumer, we expect the returns forecasted for 2023 will be realized in 2024. The last time municipal bonds had successive years of negative returns was 1980 and 1981. Of note, the returns from 1982 through 1986 were significantly above trend. A couple of market dynamics to watch include the market impact of tax-loss swapping, which in the face of strong issuance expectations could result in bid/ask spreads widening (that is the difference in the price where dealers offer to buy the bonds relative to where they sell the bonds), as brokers may be cautious about inflating inventory against the backdrop of a large amount of new bond issuance. Liquidity has been poor as of late and we have been successful at finding acceptable bids on roughly 25% of the bonds we attempt to sell. The end of the year could be good for bond desks that help clients realize tax losses (and clients may benefit to a degree as well). If yields haven’t fallen by year end, it may represent a buying opportunity as inexperienced sellers unload bonds and dealers price odd lot pieces at attractive levels to get them off their books. Recently, we have seen odd lot opportunities that offered tax-exempt yields of 4% for AAA-rated bonds in the 9-year to 12-year maturity area. That’s a pretty nice taxable equivalent yield for most buyers at current tax rates. Imagine how nice that might look at future tax rates!
"Urban centers are increasingly becoming an area where we are becoming more diligent about diversification and deterioration of credit metrics."
To prepare readers for what recession might mean for muni bond investors, we’ve discussed the record rainy day funds that should insulate many states from a downturn as well as indicating which municipal sectors may make headlines. Higher education, healthcare, transit, and issues that are exposed to the competitive pressure of the marketplace, or changing tastes remain at the top of our list of areas to avoid. Urban centers are increasingly becoming an area where we are becoming more diligent about diversification and deterioration of credit metrics. Our concern is certainly not universal, but the mounting pressures include the challenges related to commercial real estate assessed values, along with unexpected costs associated with migrants. San Francisco tax filers have asked for an average 48% reduction on property assessed at more than $60 billion. According to Boston Consulting Group, San Francisco office towers may see values plunge by 60%. Of the 2,420 appeals heard for the fiscal year ended in June, roughly 55% received a reduction. The city is facing a $780 million budget deficit through 2025, so the loss of tax revenue adds to their challenges. According to a joint study between Columbia University and New York University, offices in New York may lose 44% of their pre-pandemic value by 2029. New York City has been in the news for the tens of thousands of migrants that are expected to add nearly $5 billion in spending in the city’s $107 billion budget for this fiscal year and another $6 billion for next year. Pressed with higher borrowing costs, declining assessed values for commercial property, and the looming pension expenses, many urban municipalities will have difficult spending and tax policy decisions ahead. School districts in these same areas, as well as across the country will face challenges. According to a Georgetown University analysis, the expiration of Covid stimulus dollars will result in school districts having to cut costs by approximately $1,200 per student. In the 2024-2025 academic year, budget gaps are expected to exceed those experienced during the GFC. As an example of broader changes in preferences and demographics, the Denver public school system has lost nearly 5% of its headcount over the past five years. It seems like the tough choices for some districts will be near term and a recession would expedite the need for immediate choices.
One could reasonably ask, why can’t municipalities just raise revenue to fill the gaps? We expect that where politically feasible, that will be the inevitable solution. States aren’t immune from the stress of inflation. A report from the Urban institute shows that on an inflation-adjusted basis, June of 2023 represented the 11th consecutive month of tax revenue declines. Sales taxes held up, but income taxes did not (which is in line with our earlier comments about wages not keeping up with inflation). In dollar terms, adjusting for inflation, 2022 state revenues were $1.37 trillion as compared to $1.23 trillion in 2023. Milwaukee recently enjoyed a new 2% sales tax levy increase, with an added 0.5% county sales tax increase which will take their sales tax rate from 5% to 7.5%, to avoid spending cuts. Shoppers in Minnesota’s Twin Cities of Minneapolis and St. Paul recently saw a 1% sales tax increase to support affordable housing and transportation initiatives. The tax will apply to brick-and-mortar stores as well as to online purchases of people who live in the defined metro area footprint. In Minneapolis the new tax rate will be over 9% and St. Paul it will be nearly 10%. At the same time, Hennepin County has approved a 6.5% property tax increase for next year. Some efforts to raise revenue are simply head scratching. In an apparent effort to increase the frequency of home deliveries and boost the amount of packaging materials consumed, the State of Minnesota is adding a 50-cent fee onto retail deliveries of $100 or more. The move is expected to raise more than $60 million a year unless buyers incorporate the fee in their buying habits. We find it odd that the solution to increase funding for road maintenance will likely result in increased road usage by delivery trucks. As municipalities will eventually be under budgetary pressure, expect higher taxes and a lower level of services for taxpayers. For muni bond investors, the need to generate revenue at both the federal and state levels should make the future value of tax-advantaged income greater than what is currently the case.
Strategy and Summary
Much of what was said last quarter continues to be our strategy for this quarter. Risk spreads remain tight, and we expect the Fed is effectively at the end of the tightening cycle. It suggests that if you are not compensated for taking on credit risk, a person should own high quality and safe names. Treasuries seem to be a smart place to be as we near 2024. Prior to the tensions in the Middle East, we would have estimated that 10-year Treasury yields had a good chance at exceeding 5% by late November or early December. The slowdown we anticipate in 2024 could still produce double-digit returns on 10-year Treasuries if yields fall back to the levels seen as recently as May. As mentioned last quarter, owning long duration bonds has historically been a good strategy when the Fed is near the end of a tightening cycle. The impact higher rates have on the economy and the low probability of three consecutive “bad” years for bonds makes us think that this episode won’t be any different. Mean reversion tends to matter in the arena of investment strategy. Whether it is the decline in leading indicators, the shrinking money supply, or the record number of days of inversion of the 3-month Treasury as compared to the 10-year Treasury, so many historically relevant indicators are suggesting tough economic times are imminent. Municipal bonds may offer some opportunity in the 4th quarter based on robust supply of new bonds that is stressed by tax-loss selling and dealers who may not want to carry odd lot positions over yearend. Markets seem charged to deliver volatile times with geopolitical tensions meeting the exhaustion of the suspension of disbelief that, in fact, the jack-in -the-box we all know is eventually coming (the recession) finally shows its ugly face. For bond investors, the heart pounding surprise could lead to a relieving 2024.
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