October 2023 Market Commentary
October 24, 2023
Maybe it is a sense of melancholy from summer drawing to a close. Perhaps it is traders returning from late-summer vacations and refocusing on the job at hand. More likely it is something else entirely. Whatever the reason, since 1928 September has been the worst calendar month of the year for the S&P 500, with the venerable index experiencing an average loss of 1.2%. September 2023 was no exception, as the S&P 500 fell 4.9%, its worst monthly decline since December 2022. Higher interest rates were the primary culprit, driven by a rebound in inflation, the Fed’s continued hawkishness regarding monetary policy, a growing acceptance by investors of interest rates remaining “higher for longer”, renewed concerns about the country’s debt, and other inflationary factors such as higher oil prices and the current auto workers’ strike.
All of those factors coalesced to drive interest rates higher across the yield curve, in many cases to levels not seen in 10 years or more. That was particularly true for longer-dated Treasuries which saw the 10-year yield rise 0.46% to end the month at 4.57%, while the 30-Year Treasury gained 0.49% to end at 4.70%. Intramonth, yields on the 10- and 30-Year Treasuries peaked at 4.69% and 4.81%, respectively, their highest levels since 2007 and 2011. At the short end of the curve, rates experienced smaller moves, with the 2-Year Treasury yield rising 0.18% to end at 5.04%, while the 3-month was virtually unchanged, up just 0.01% to end at 5.45%.
With so many factors driving interest rates, it’s helpful to explore each one to better understand the way(s) in which they impact rates. At the short end of the curve, interest rates are largely determined by the Federal Reserve which, as expected, left rates unchanged at its September meeting. However, the release of its updated interest rate projections indicated one additional 0.25% rate hike in 2023 remains possible. More importantly, the Fed lowered its projected rate cuts for 2024, from four to two. The combined effect was to maintain upward pressure on short-term rates and reinforce the Fed’s intention of keeping interest rates “higher for longer.”
At the long end of the curve, market forces play a much larger role in determining interest rates.
Higher for longer- Refers to the idea that once the Fed raises interest rates to a level it deems “sufficiently restrictive”, it will maintain rates at that level until it is confident inflation is moving back down to the Fed’s longer-term target of 2% in a “sustainable” way. And while the idea of higher for longer generally refers to short-term interest rate expectations, it appears to have bled into intermediate and longer-term interest rate expectations as well.
Inflation- An uptick in headline consumer inflation (CPI) in August, to its highest level since May, bolstered the Fed’s case for an additional rate hike before year end. The increase was largely the result of higher energy prices. However, a strike by the United Auto Workers (UAW) union raises the possibility of continued upward inflationary pressure in the form of higher prices for new vehicles, which have already increased 24% to $48,450, since the start of the pandemic. In general, the longer inflation remains elevated, the more inclined the Fed will be to maintain rates near current levels, or even increase them depending on how the path of future inflation evolves.
Government debt- Concerns about the country’s debt, either in absolute terms or as a percent of GDP, tend to be episodic and most typically voiced by the political party out of power. The reality, however, is that the country’s total debt levels have increased every year, without exception, since at least 1980, regardless of the party in power. One concern about rising debt levels is that as they increase, so too does the amount of interest that must be paid, in turn limiting discretionary government spending and by extension economic activity. Over the past 40 years, as US interest rates steadily declined, increased borrowing did not necessarily translate to higher borrowing costs. That has changed significantly since 2020 when the US paid just over $500B in interest to service its debt. Currently, due to higher interest rates and continued borrowing since 2020, it now costs ~$800B to maintain the debt, or ~15% of annual government spending. By some estimates, interest expense on the debt will exceed $1T by FY2025. According to the Congressional Budget Office, the cumulative deficit for the 2024-2033 period is projected to total ~$20T, which would push total debt to over $50T. Given the need to issue such large amounts of additional debt, and the growing concerns about the government’s ability to repay it, it is understandable that investors would demand higher yields to be compensated for their perceived risks. At the same time, higher yields on other sovereign debt have provided investors with increasingly attractive alternatives to owning US debt, thereby putting additional upward pressure on US rates.
Economic optimism- Increased optimism surrounding the US economy has led many economists to rescind or reduce their near-term calls for a recession. Goldman Sachs joined the growing list in September, lowering its odds of a recession within the next 12 months from 35% to 15%.Expectations of stronger future growth naturally fuel expectations for higher inflation, thereby driving longer-term rates higher.
One interesting result of the recent move in longer-term rates has been the dissipation of the yield curve inversion observed over the past year. Under normal conditions, longer-term rates are higher than shorter-term rates. However, during periods when the Fed raises short-term rates to cool inflation, longer-term rates fall as investors price in slowing economic activity, or even a recession. The result is often a yield curve inversion where short-term rates exceed longer-term rates. Typically, the yield curve returns to its normal shape as economic activity slows and in response the Fed lowers short-term rates to spur demand. That in turn boosts optimism for an economic rebound and with it an increase in long-term rates back above short-term rates. When the curve corrects through such a mechanism, it is referred to in fixed income parlance as a “bull steepener.”
Interestingly, in September, the narrowing of the yield curve inversion resulted from a “bear steepener.” In this case, the yield curve shifted towards a more normal shape due largely to a rise in longer-term rates, as short-term rates remained relatively stable. The rise in longer-term rates coupled with already high shorter-term rates resulted in even tighter financial conditions, i.e. the ease or ability for individuals, investors, and businesses to access capital.
Similar to 2022, higher rates weighed on equity markets in September. Domestic equities were more heavily impacted than their international brethren with large caps (S&P 500) falling 4.9%, while more economically sensitive small caps (Russell 2000) fell 6.0%. Overseas, international developed markets (MSCI EAFE) dropped 3.7%, while emerging markets (MSCI EM) declined 2.8%.
Bond markets were not immune to the rise in rates either with the Bloomberg US Aggregate Bond index, the broadest measure of the US bond market slipping 2.5% as Treasury yields undertook a steady march higher due to factors previously discussed.
Municipal bonds, which had outperformed in recent months, as they typically lag movement in the Treasury market, gave back some of that outperformance. For much of the year, munis had benefitted from low supply in the face of continued demand. Demand, however, waned a bit in September with rising yields, and the fact that late summer is historically a fairly slow maturity/reinvestment period for municipal bonds.
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