Bond Market Update: Consequences and Opportunities
November 7, 2023 by J.D. Wolfsberg:
As the Federal Reserve has moved forward with its plan to lower inflation, interest rates have risen across the board. When the Fed began its rate-hiking campaign, bond markets were pricing in the Fed reducing rates by the end of 2023 as the average tightening cycle is close to 21 months. Clearly, this did not materialize and the market needed to readjust to a ‘There are a few reasons why it will take time for higher rates to flow through to the system and slow the economy.
We just received a 3rd quarter GDP number which exhibited unquestionably strong growth powered by the US consumer. Consumer finances have remained in good shape as evidenced by increases in consumer’s personal income, disposable income, and personal savings. Spending that requires forms of leverage, including capital improvements, will likely eventually slow as higher rates start to take hold. That said, the question every economist is asking themselves is not if these higher rates are going to slow the US economy but when we are going to see this slowdown take place and the implications for financial markets and risk assets.
Looking at the US population, mortgages for many Americans represent their largest borrowings. As 30-year fixed rate mortgages bottomed out under 3% during the pandemic, it made buying a home more affordable and resulted in current homeowners refinancing their current mortgage to take advantage of the low rates. In the summer of 2023, Zillow reported that 80% of mortgage holders had locked in rates less than 5%. At the time of this writing, however, the current 30-year fixed mortgage rate is now approximately 8%. The implication is that current homeowners are likely going to want to stay put for the time being and hold on to their current rate. I can speak from a personal perspective that my family’s starter home is starting to look like the ‘until my girls are out of college’ home. Auto-loan and Credit Card rates have also increased, making buying cars and carrying balances much more expensive for the consumer.
Locking in low interest rates was not exclusive to the consumer during 2020 and 2021. Large corporations termed out their debt and issued $2.3 trillion and $2.0 trillion in 2020 and 2021 respectively, according to SIFMA. Since rates have risen starting in 2022, borrowing by corporates has dropped dramatically from these levels. Investment Grade corporations have the benefit (due to their high credit rating) of being able to issue debt beyond 10 years in maturity, and many did so in 2020 and 2021.
One reason it will take time for interest rate increases to flow through to the system is that consumers and highly rated corporations were able insulate themselves, to some degree, from higher rates up until this point. However, rates at these levels will start to slow spending and business investment as we move forward; this will likely begin to show up in the economic data over the next 12 months. As an example, consider a Home-Equity Line of Credit (HELOC) for a home renovation for the consumer. Two years ago, this interest rate may have been around 3%, now these rates (as they are variable) stand closer to 9%. Anyone looking to access their HELOC for a renovation may have been quick to do so two years ago, but will evaluate this decision more closely in 2023 and moving forward; that said, cash savings on the sidelines may become an option for funding these projects or foregoing the improvements altogether. Businesses that could source debt at 2.5% two years ago to fund projects and acquisitions had a lower required rate of return on that project to clear the cost of capital. We are now in a higher-rate era that will require more thoughtfulness and patience by consumers and businesses alike before leveraged spending decisions are made.
There are pockets in the economy where we are starting to see the slowdown take place. The most obvious place is the Commercial Real Estate (CRE) space where lending has contracted due in part to what took place with Silicon Valley Bank and Signature Bank in March of 2023. Regional banks provide a majority of lending to CRE investors, and the bank crisis caused a ripple effect. Quickly after the announcement investors poured through bank balance sheets attempting to research which other financial institutions may have had a bond portfolio that sold off so dramatically in 2022 that if it were marked to market, the bank would not be as well capitalized as publicly reported (you may recall that we touched on this in the 1st quarter market review). This, coupled with issues in the office space sector, caused banks to reevaluate and tighten their lending practices. The tightening is having a slowing effect on this sector which is bound to trickle-down to other parts of the economy.
There are silver linings when looking at this through the lens of an investor. The S&P 500 has rallied this year driven by a handful of stocks nicknamed ‘The Magnificent 7’: Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla. When looking at the remaining companies in the index, there hasn’t been a large repricing of companies, on average, from 2022 levels. There may be more volatility in the near term due to concerns over the economic atmosphere, interest rates, and geopolitical conflicts, however, earnings over the last few quarters have come modestly above expectations. Factset currently expects earnings growth for 2023 to be slightly positive. Indicators also point to a bearish sentiment among investors given the level of uncertainty regarding the trajectory of the economy and interest rates. This can actually be a bullish signal for equities.
The current rate environment is providing opportunities in bond markets not seen since the financial crisis. Yields for Investment-Grade corporate paper are now between 5.25% – 6%. Even the most conservative investors are enjoying money markets, now earning approximately 5% thanks to the Federal Reserve’s rate hikes.
Image Source: Morningstar Direct, 10/27/23
We are currently monitoring the landscape and we are here as always to provide guidance and management through uncertain times. If you have any questions about your portfolio and how our team is positioning, please don’t hesitate to reach out.