Trick or Treat?
What happened last week?
- The S&P 500 declined -2.53%
- The Dow Jones retreated by -2.14%
- The Nasdaq plunged -2.62%
Stocks have been under pressure since July 31 on rising rates, so it’s easy to view the recent market turbulence as a trick. However, we believe this will give way to a treat for investors as earnings grow and interest rates come down in 2023–2024.
To explore the opportunities in today’s bond market, please see our weekly CIO Strategy Bulletin below.
3 Things to Know
US Treasury Yields at Multi-Decade Highs
The Term Premium is the additional yield demanded by investors to stay in longer duration bonds rather than getting repayment sooner.
It encompasses uncertainties such as increased geopolitical risk, the possibility that inflation could spike unexpectedly, possible fiscal deterioration, and most importantly the risk that short-term yields could be higher in the future.
The Household category of bond buyer is currently demanding additional yield to take on this “uncertainty risk”.
Although “real yields” as measured by TIPS do not capture term premium alone, the spike in real yields to one of the highest levels since the early 2000s illustrates that term premiums have risen.
Even as inflation expectations (as measured by TIPS) have been largely stable between 2.25%-2.50%, nominal yields continued to rise.
Inflation Likely to Slow in 2024, Leading to Lower Yields
We already see headline inflation abating from 9.1% in June 2022 to 3.7% in September 2023. This suggests progress in rebalancing supply and demand as supply disruptions have cleared and demand has stabilized.
And if we reach a 2.5% inflation rate by the end of 2024, it will almost certainly get there due to the retrenchment of the important “shelter inflation” category.
The risk of and economic recession grows as rates move higher. The effect of higher-for-longer rates and the recent bear steepening of the curve slows economic growth and suggests that unemployment may rise more sharply than is currently expected.
Geopolitical risk has also increased, leading to higher market volatility generally. If long-term rates remain durably higher, then additional pressures on the economy may yet emerge.
It is our view that the market will shift its thinking and begin to build in expectations of rate cuts, leading the Fed to actively engage in cutting rates by the second half of 2024 to keep employment losses to a minimum.
Therefore, Citi Global Wealth Investments believes current yields on high quality bonds provide a compelling potential opportunity to lock-in durable portfolio income for many years.
The Current Scenario: Potentially Higher for Longer
Investment grade bonds of intermediate duration as well as municipal bonds for suitable investors who may benefit from the tax treatment also offer extremely high yields compared to the past 15 years, with returns well above both the expected breakeven inflation rate as well as the “longer-term” Federal Reserve “neutral” Fed Funds rate of 2.5%.
Investment Grade bonds with maturities of five years currently offer yields around 6.25–6.5%, while intermediate highly rated municipals pay around 3.5% before tax adjustments.
We also think investors may want to consider even slightly lower-rated securities, such as BB-rated bonds that currently pay over 8%, or even investment grade preferred securities which also yield slightly over 8%.
As discussed last week, the risk of entering new bond positions is materially less now than it was just 18 months ago.
Treasury coupons have moved from near zero to almost 5% today and their price sensitivity (effective duration) has been sharply reduced. And the bond yields across the range of securities have more than doubled since 2021.
What does this mean for investors?
Like select equities, the bond market offers potential opportunities for investors heading into 2024 and beyond with its compelling real yields.
We foresee a time in 2024 when rate pressures recede and the US dollar declines.
This could help set the stage for stronger global growth in 2025. If this pattern unfolds, we are likely to broaden our global equity overweight positions to include other regions, industries and market sectors.
Examples include US and European energy producers whose low valuations, strong balance sheets, dividend income, and inflation protection are potentially appealing. But for now, investors should consider this higher for longer scenario.
See our weekly CIO Strategy Bulletin for more details