INSIGHTS

On September 11, 2023

AAM Viewpoints — Summer Scorcher Sets Tone for Higher Long-Term Rates

With summer officially over and the 3^rd quarter (Q3) winding to a close, the resilience of the U.S. economy throughout the summer months has renewed hopes the Federal Reserve can engineer a soft landing and avoid recession. The bears have changed their tune, odds of a recession are falling and some GDP models, such as the Atlanta Fed GDPNow, are calling for Q3 2023 GDP as high at 5.6%. The current macroeconomic backdrop stands at odds with the narrative to begin the year, which called for economic weakness in the second half and a Fed pivot to lower rates to finish out 2023. Markets supposed to usher in a “kinder, gentler” monetary policy from the Fed resulting in less price volatility in bond markets and paving the way for a strong recovery coming off one of the worst years in the history of bonds. In fact, the summer months were anything but gentle on the U.S. bond markets with the 10-year U.S. Treasury closing at 4.34% in late August, a level last seen in 2007, and the 30-year U.S. Treasury hitting 4.45%, the highest since 2011. August closed out a four-month streak of losses for the ICE BofA U.S. Treasury Index, and by September 5 U.S. Treasuries had given back all 2023 gains to finish down 0.30% on a year-to-date-basis. It is easy to pin the blame for the recent rate volatility on the Federal Reserve, but long-term rates have been moving up much faster than short-term rates. Stronger-than-expected growth should necessitate higher long-term yields but there seem to be other factors at work as well. The potential for inflation to settle in near 3%, or possibly even reaccelerate amidst growing concern over the state of U.S. finances, also seem to be playing a role.

Expectations for the balance of 2023 now stand in stark contrast to the prevailing school of thought to begin the year, which called for recession and a Fed pivot to lower rates by year end. The FOMC (Federal Open Market Committee) is likely to increase their 2023 median GDP estimate with the release of economic projections at the next meeting slated for September 19­–20. The last FOMC Summary of Economic Projections, released in conjunction with the June 13–14 meeting, pegged 2023 median real GDP growth at 1% which, three months removed, is now well below consensus expectations. The FOMC could more than double that estimate at the upcoming September meeting after a summer string of better than expected economic data. Consumer spending was vigorous in June, July, and August. All eyes are focused on the “Barbenheimer” effect — the estimated 0.6% boost to consumer spending in July and August from movie, concert, and related summer expenditures. The U.S. labor market remains robust even after an unexpected uptick in the unemployment rate with both initial jobless claims and continuing claims coming in lower-than-expected last week. Factory orders and residential investment have also all surprised to the upside in recent weeks alongside the strong ISM (Institute of Supply Management) Services print last week that drove U.S. Treasury markets into the red for the year. While the Atlanta Fed GDPNow model is notoriously volatile and likely overstates Q3 GDP at 5.6% anything better than 3.2% would represent the strongest quarter of growth since the COVID recovery in 2021. The lagged impact of restrictive monetary policy, including short-term rates north of 5% and tightening lending standards, have likely yet to take their full toll and the yield curve inversion is suggesting the Federal Reserve will likely push the economy into recession at some point. That said, in the near term, unexpectedly strong economic growth likely biases long-term rates to the upside heading into the end of the year.

Stronger than expected growth also calls into question the Fed’s ability to pull inflation down to their 2% target and could require a “higher for longer” stance by the Federal Reserve. Even inflation that settles in near 3% is likely to keep rates elevated. Fed Funds futures markets are currently pricing in 100 basis points of cuts in 2024, which matches the Fed’s own projections from the June meeting. Markets cannot have it both ways. Rate cuts in the face of strong economic growth are a rare occurrence and do not fit the Fed’s playbook. The odds of a final Federal Reserve rate hike before year-end are now a coin flip at the November 1 meeting with markets pricing in a pause in September. The expected path of Fed Funds over the next 6–12 months is likely more important than the prospects for another hike. If economic projections coming out of the next Fed meeting show officials at odds with bond markets on the expected path of Fed Funds in 2024, it could provide further impetus for rates to move higher. In addition, there are reasons to think inflation could be sticky in the 3% range. Wage growth remains strong, input costs remain high, and the base effects that drove the CPI (Consumer Price Index) down into the 3% range in June and July are set to wane by year-end. Energy and commodity prices have also increased significantly over the summer months which could pressure Headline CPI to the upside through the balance of the year. Core CPI remains stubbornly high at 4.7% and the Fed’s own preferred measure of inflation, PCE, also remain elevated with Core PCE north of 4%. In addition, measures of inflation expectations such as TIPS (Treasury Inflation-Protected Securities) breakevens are moving higher after setting post-COVID lows in July. Economic strength and hotter-than-anticipated inflation tend to go hand in hand, and it should not be a surprise if concern over inflation begins anew through the balance of 2023.

While macroeconomic factors, such as higher-than-expected GDP could pressure rates in the near term, business cycles are normally short-lived in the face of secular drivers of interest rates. The end of the quantitative easing era has ushered in a new era of inflation and higher interest rates, alongside growing deficits, are beginning to call into question the state of the U.S. balance sheet. While it may be some time before markets can call an end to the 40-year secular bull market in bonds, the 10-year U.S. Treasury has set six successive tops since bottoming at 0.51% in August 2020. Successive highs and successive lows are the hallmark of secular bear and bull markets and weakening U.S. finances have been noted by some observers as possibly providing the secular driver for a longer-term bear market in bonds. In the last few months, the U.S. has staved off a debt ceiling impasse, lost a AAA rating, increased debt issuance against an already historical deficit and reported interest rate servicing costs ballooning by more than double to over $1 trillion a year all against falling tax revenues. Furthermore, increased issuance comes in the face of slowing international demand, a Federal Reserve looking to reduce its $8.1 trillion balance sheet, and a glut of retirees set to push up the cost of safety net programs such as Social Security and Medicare. The downgrade of U.S. sovereign debt simply called out what was there for all to see, and long-term rates have responded accordingly but likely nowhere near enough. U.S. fiscal deterioration should add up to a healthy term premium, or additional yield for additional duration. To be fair, longer-dated term premiums have moved higher, but the U.S. Treasury curve remains inverted, and some estimates of term premiums are still negative, which leaves longer-term interest rates with a lot of room to the upside.

Bond yields at their highest levels in over a decade certainly warrant a growing comfort with duration. That said, a short to intermediate stance could be warranted for the foreseeable future. It might be some time before investors should search for yield on the long end. The inverted curve creates a silver lining with the highest yields in the market in the short-to-intermediate maturities. With little to no term premium for investing in longer-dated bonds, investors are likely not compensated for the duration much less the risk that long-term rates continue to move higher.

CRN: 2023-0901-11087 R