TheChek News Flow

A big year-end rally faces challenges including inflation and the deficit

A resilient U.S. economy and cooling inflation fueled an intense year-end bond rally. Now, some suspect investors are too sanguine about the months ahead.

The rally marked the latest in a series of swings that sent the yield on the 10-year U.S. Treasury, which falls when bond prices rise, leaping and diving throughout the past 12 months. Fears of a prolonged stretch of higher interest rates repeatedly drove the yield to decade-plus highs, only for stress on the banking system and a Federal Reserve pivot to drag it down again.

The yield has fallen a full percentage point since topping 5% in October for the first time in 16 years, easing worries it would hurt the economy by raising borrowing costs on mortgages, corporate loans and other forms of debt. Many investors and economists are now predicting a so-called soft landing, expecting inflation to subside without a spike in unemployment or a recession.

Plenty of challenges could still roil the bond market. The growing fiscal deficit is set to spur another deluge of U.S. Treasurys, more companies will need to refinance their low-rated debt, and the final legs of the Fed’s fight against inflation are likely to prove the trickiest.

We asked five investors whether we are past the inflationary surge and avoiding a recession.

George Bory, chief investment strategist for fixed income at Allspring Global Investments, says the risks to the macroeconomy hinge on the market’s biggest assumption: that inflation will fall smoothly and orderly toward the Fed’s 2% target.

Bory is among those who think the hardest part of the inflation fight will be getting the central bank’s preferred measure of price increases—the core PCE index—down to 2% from the latest 3.2%. Treasury Secretary Janet Yellen said in December that she doesn’t think the last mile will be “especially difficult” and expects the economy to glide into a soft landing.

“Our base case is inflation does come down, but not as orderly as the market thinks,” Bory said. “Ultimately getting to 2% will be challenging for the Fed without a notable slowdown in growth.”

Bory doesn’t rule out a range of outcomes that could drag Treasury yields lower or propel them higher. If elevated borrowing costs ultimately choke off the economy’s steam, a recession could drag long-term bond yields closer to 3%. Meanwhile, a reacceleration of inflation could be “meaningfully disruptive,” bringing 6% yields into view.

He favors bonds from companies that are prepared to cope with higher rates. His message to bond investors: Hunt for quality companies that have the cash flows to meet any refinancing needs over the next few years.

“The most important thing to focus on in this cycle is the path to refinancing,” he said. “If there is a clear path and management is able to articulate their strategy, we like that credit.”

James St. Aubin, chief investment officer at Sierra Mutual Funds, is worried that higher rates and tougher lending standards by bankers are beginning to bite.

“Those two things in concert usually put a lot of pressure onto the economy, and ultimately move it into a recession,” he said. “The long and variable lags of monetary policy shouldn’t be ignored, and I think they are right now.”

Markets might succumb to “the curse of high expectations” in 2024, he added.

Rising rates have slowed the economy in previous decades in part by forcing lenders to go on a diet. Banks usually pull back on making risky loans when they are worried about being paid back, or seek to borrow less because the Fed has made it more expensive.

The model soft landing was engineered by the Alan Greenspan-chaired Fed in 1995: The central bank doubled the fed-funds rate to 6% before cutting it back, without spurring a slowdown. Notably, banks didn’t restrict their lending. Today, they are tightening terms on everything from individual borrowers to big corporations.

St. Aubin says corporate debt markets face the most acute threat this coming year, as companies eventually have to refinance at higher rates. Stress in the credit markets could cascade into stocks.

Investors aren’t acting worried. The extra yield they demand to hold corporate bonds instead of ultrasafe Treasurys is near multiyear lows. (Investors typically demand higher yields for corporate bonds when they are concerned about a slowdown spurring defaults.) So-called credit spreads are similarly tight even on low-rated bonds.

“Everyone always sees a soft landing just before a recession,” said St. Aubin. “Then something happens. Things slow down abruptly.”

Rick Rieder, BlackRock’s chief investment officer of global fixed income, says he has never been more excited about heading into a new year.

“We haven’t seen three years of returns in 10-year Treasurys as negative as they have been in 150 years,” he said. The recent aggressive recoil in bonds proves that “the only way to generate a big splash of returns is on the backside of prices recalibrating.”

Bondholders are enduring their worst spell on record. Consecutive years of negative returns were unheard of before 2022, when the Fed’s rapid rate-increase campaign sent bonds to their worst annual losses in U.S. history.

“The only thing I’m a little disappointed about is how fast the markets are moving—it’s way faster than historically, including what is being priced in for the Fed.”

Fed officials penciled in three quarter-point rate cuts in 2024 at their December meeting, which would take the benchmark interest rate to around 4.6%. Traders are wagering that the Fed will slash its benchmark rate below 3.9%, kicking off cuts in March, according to FactSet. Expectations for a wave of rate cuts have boosted Treasury prices, dragging yields lower.

Why is Rieder so eager for 2024? Investors can pocket a lot of yield without taking the risks needed to generate similar returns in recent years.

“Do you need a lot of low-quality leveraged loans? CCC-rated bonds? Mezzanine commercial real estate risk? No,” he said. “This is an environment where you can clip 6.5% to 7% without taking that risk.”

Rieder likes investment-grade bonds, agency-backed mortgage-backed securities and European corporate debt.

“This year, the traditional 60/40 portfolio was carried entirely by the stock market before this bond rally,” he said. “My sense is next year, fixed income will be a bigger part of portfolio return.”

Frances Donald, global chief economist at Manulife Investment Management, says the market is underappreciating the odds of a recession, or inflation dropping below the Fed’s 2% target. Both would mean yields have much more room to fall.

“Everyone is focused on the hard versus soft landing debate,” she said. “But under the surface, we already have the longest manufacturing recession ever seen.”

The manufacturing sector has been contracting for more than a year, according to an Institute for Supply Management survey. Donald points out that shares of smaller companies, stocks that are typically sensitive to the economic outlook, lagged behind the broader market for much of the year. Corporate spending on new projects is “swan diving lower,” the buying and selling of existing homes has hit lows unseen since the financial crisis and U.S. exports will likely suffer from global growth slowing.

The trade: Despite a potentially bumpy road ahead for bonds, the heap of pressures means investors should buy them, according to Donald.

Why invest in an economy with so much trouble looming?

“The U.S. is likely to be the ‘cleanest dirty shirt’ ” on the global stage, Donald said. “Investors looking for a place to hide—they’ll go there.”

Torsten Slok, chief economist of Apollo Global Management, says the market is too focused on the Fed and not enough on Washington’s surging bond issuance and expansionary fiscal policies.

The U.S. government is set to issue substantially more debt in the first quarter of 2024 than it did in the same period of 2023, which went on to set an annual record. That is assuming there isn’t a recession. If there is, the government would likely have to issue even more bonds to make up for revenue shortages and to finance unemployment benefits.

“There’s a tug of war between the Fed at one end of the rope and the supply of Treasurys at the other end,” he said. “The market needs to take the bond supply more seriously—and in my view it will be paying more attention to Treasury auctions than ever before.”

Treasury auctions have already attracted scrutiny, worrying investors that demand for U.S. debt is waning. Concerns that supply will outpace demand should lift long-term Treasury yields even as the central bank cuts short-term rates.

Slok also thinks the Fed’s recent pivot toward forecasting rate cuts, which sparked a rally in markets, is complicating its battle against inflation.

“The pivot is easing financial conditions through much lower rates, stocks rallying and tightening credit spreads,” said Slok. “You potentially risk that the pivot provides its own boost to growth and inflation in the coming quarters.”

A number of indicators point to the economy reaccelerating, according to Slok, including booming housing starts and renewed confidence among home builders as mortgage rates have fallen. The Atlanta Fed GDPNow Forecast currently shows fourth-quarter growth as likely to print at a 2.3% annual rate, which would build on 4.9% growth in the third quarter.

“The market seems to think the inflation problem is solved and there’s nothing to worry about,” he said. “We’re starting to move from a soft landing to a no landing scenario, where the Fed is not done and must hold rates higher for much longer.”