With our annual Solving for 2024 outlook just around the corner, we’ve recently been discussing some of the key themes we anticipate for the year ahead.
In fixed income, we think a key theme will be one that most strategists did not have in their outlooks for 2023, but which was nonetheless prominent and could persist into 2024: the overwhelming importance of bond-market supply and demand in setting prices and yields, which at times superseded the direction suggested by economic and credit fundamentals.
We think it is worth singling this theme out. As we close in on the end of this historic tightening cycle, central bank policy is subsiding as a source of uncertainty, and the ebb and flow of supply and demand may take on more importance.
Coffers Were Full
Through the fourth quarter of 2022, U.S. and global growth outlooks were becoming steadily more pessimistic. By the end of the year, for most economists and strategists the debate was not if, but when, the recessions would occur during 2023.
What happened to credit spreads?
For the ICE BofA Global High Yield Index, they went from almost 590 basis points at the start of the fourth quarter of 2022 to as low as 430 basis points by March 2023. For the Bloomberg Global Aggregate Corporate Bond Index, they went from around 180 basis points to less than 130. For the ICE BofA Global Hybrid Corporate Index, they tightened from 340 to 240 basis points. The mini-banking crisis in March caused a spike, but spreads have drifted tighter again through the rest of the year.
Was this because the U.S. economy unexpectedly continued to grow, even as China and much of Europe stagnated? Perhaps—but that wouldn’t explain why we saw the same journey in European high yield and emerging markets spreads.
A much better explanation, in our view, is the dearth of new corporate bond issuance in the first half of the year. Throughout much of 2021 and 2022, corporate issuers financed aggressively relative to their needs, taking advantage of record-low rates. That meant many coffers were full by the close of 2022. Bond market inflows have been modest this year because many investors have been happy to sit in cash or money markets earning 5%. But with high yields now on offer, the inflows weren’t negative—and when that modest demand met almost nonexistent supply, it tightened spreads.
A Massive Supply Shift
Right now, of course, attention is focused on the rates market rather than credit markets. Core government bond yields have burst out of their 2023 trading ranges, with the 10-year U.S. Treasury yield adding some 65 basis points in little over a month to trade higher than at any time since early 2007. What might be going on here?
Well, certainly the U.S. Federal Reserve’s steady drumbeat of higher rates for longer—even though inflation has been declining—is settling into the market psyche. It’s difficult to lay the blame on changes to fundamental inflation expectations: The move in the nominal yield curve has been matched by a move in the real yields, leaving inflation expectations unchanged. Instead, meaningful changes in the supply-and-demand dynamic appear to be playing a large role here, as well.
The August Treasury refunding saw a significant lift in coupon issuance, and the market has come to the realization that this is the beginning of a durable trend. While the Fed’s shift from quantitative easing to quantitative tightening has been well telegraphed and understood by market participants, the Treasury’s growing fiscal deficit is surprising on the high side. Together, they currently amount to close to 10% of U.S. GDP, with quantitative tightening accounting for around 3%.
Spending continues to rise, while revenues have dropped by 10% for the fiscal year-to-date relative to 2022, largely due to a heavy decline in capital gains tax receipts. The deficit is expected to be around $1.6 trillion this year, versus around $1 trillion last year. Current forecasts for 2024 are around $1.8 trillion, with rising interest expense continuing to contribute much of the lift. We think this means Treasury coupon issuance could roughly double from this year’s level of just over $1 trillion to as much as $1.9 trillion in 2024—a massive supply shift.
On the other side of the equation, in addition to the Fed going from large-scale buyer to seller, U.S. commercial banks, traditionally a major source of demand, are mostly absent because their existing bond holdings are both large and underwater, and because of heightened market and regulatory scrutiny following the mini-banking crisis earlier in the year.
The offshore bid for U.S. bonds—an important source of demand ever since the global financial crisis—has also been all but eliminated as the rapid rise in U.S. short rates relative to those in many other markets has resulted in prohibitively high currency-hedging costs. Finally, active money managers (ourselves included) would usually have been keen to take advantage of such a dramatic rise in yields by adding portfolio duration, but holdings analysis and sentiment surveys suggest that, as a group, money managers have already spent much of their firepower.
Sources of Demand
Does this mean the march to higher yields will continue unabated? Not necessarily. Three particularly large sources of demand loom on the horizon.
The massive and ever-growing mountain of cash residing in money-market funds and other short-term investments could start to move as soon as there is a whiff of change to monetary policy in the air. Likewise, as long-duration, high-grade corporate bond yields move into the 6 – 7% range, liability-driven pension fund investors may start to shift allocations toward them.
Finally, while short- to intermediate-term correlations between Treasuries and risky assets have been consistently positive recently, that could change rapidly if risk aversion rises, creating a potentially strong bid for bonds.
With such strong, shifting supply-and-demand forces waiting to exert themselves in Treasury and credit markets, investors would do well to be ready for sudden regime changes and volatile price action.
We have waited a long time for value to return to fixed income markets. With nominal yields at levels we haven’t seen in 16 years, combined with an attractive move to higher real yields, we are generally comfortable clipping a healthy coupon in today’s market, even if the ride has become bumpier and is likely to stay that way.
Tighten seatbelts—and count the income.
In Case You Missed It
- U.S. ISM Manufacturing Index: +1.4 to 49.0 in September
- JOLTS Job Openings: +690.0k to 9,610k in August
- U.S. ISM Services Index: -0.9 to 53.6 in September
- Eurozone Producer Price Index: -11.5% year-over-year in August
- U.S. Employment Report: Nonfarm payrolls increased 336k and the unemployment rate held to 3.8% in September
What to Watch For
- Wednesday, October 11:
- U.S Producer Price Index
- Thursday, October 12:
- U.S Consumer Price Index
- China Consumer Price Index
- China Producer Price Index
- Friday, October 13:
- Eurozone Industrial Production
- University of Michigan Consumer Sentiment (Preliminary)