Investors on Main Street have spent the last year rediscovering what it’s like to earn interest on bond and money market funds. But for the professionals who manage these vehicles, a new series of frustrations are surfacing.
Bond managers have been conditioned by almost 15 years of ultra-low interest rates and the Federal Reserve’s efforts to hold off sharp declines in equites, what’s been called the “Fed put.” Sooner or later, these investors assume, the central bank will bring rates down again, and they keep waiting for this pivot like unemployed actors waiting for Godot. That moment hasn’t come, yet neither has the recession many of the smartest minds in economics have expected.
Like the stages of grief, the acceptance of a new economic reality has proved challenging for bond investors and economists. But few have embraced the new circumstances as quickly as Loomis Sayles vice chairman Dan Fuss, who spent the 1970s managing Yale University’s endowment.
Fuss isn’t expecting double-digit inflation or interest rates. He does, however, expect a subdued replay of the 1970s—that inflation will rise in several mini-cycles and the fed funds rate will climb into the high single digits later in this decade. “The effective impact of more money means consumption will go up and prices will go up meaningfully,” he says.
More market participants think the Fed’s 2% target for inflation could prove elusive, and that the measure will swing around 3.5% or 4%. “The Fed is going to [have to] decide how quickly they want to get to 2% in an election year in 2024,” says Permanent Portfolio CEO Michael Cuggino. Like Fuss, he is dubious that target will be met.
Brad McMillan, chief investment officer of Commonwealth Financial Network, delivered a similar message to advisors at the firm’s annual conference this year in Denver. Over the last 70 years, interest rates have mostly fluctuated between 4% and 8%; the two exceptional periods were the 10 years from 1975 to 1985 and the pre-Covid decade. McMillan says that when he mentions the possible 8% upper limit it jolts people anesthetized by the rates of the previous decade.
But as both the 10-year and 30-year interest rates danced around 5.0% in mid-October, there’s now real concern about future interest rates and the bond market’s capacity to consume a surge of new bond issues from the U.S. Treasury. With the economy running at full employment, the federal budget deficit of $1.6 trillion is now about 8% of GDP, requiring the Treasury to sell about $130 billion of bonds a month. The deficit was only 2.6% of GDP in 2016, but rose to 4.8% in 2019—and then soared during the pandemic.
The CEO of DoubleLine, Jeffrey Gundlach, has described the bear market in bonds as a “40-year regime change.” At a company event in October, he voiced amazement that no one was talking about the interest expense problem for the federal government. Before the pandemic, he worried the budget deficit could reach $2 trillion in the next recession. Now it’s within striking distance of that figure while unemployment nears a 50-year low.
At the same time, this has given investors more reason to be attracted to bonds. All you have to do is look at what it took to earn a 5% yield in late 2021. At that time, investors “needed to buy a junk bond and leverage it 50%,” Gundlach said. Today, one can buy short-term Treasury bills and get 5%.
So after a brutal 2022, 2023 was supposed to be kinder to bond investors than the first 10 months turned out. But the bullish case for fixed income today, argued by many like the strategists at bond giant Pimco, rests on the assumption that both growth and inflation have peaked.
Meanwhile, most of the leading economic indicators have been flashing recession signals for the better part of two years, prompting some, like MFS Investment Management’s chief economist and portfolio manager Erik Weisman, to conclude that either the economy has fundamentally changed or monetary policy lags have been elongated by the pandemic and unprecedented stimulus. Larry Summers, the former U.S. Treasury secretary, was among the first to see that inflation was going to stick around, though he and others have been wildly wrong about employment. He’s now questioning whether monetary policy still works.
Not everyone is buying into the “higher rates for longer” narrative. “We see greater recession risk than the markets are pricing in,” said Pimco executive vice president Nicola Mai, managing director Tiffany Wilding and global fixed-income chief investment officer Andrew Balls in an October 11 outlook paper. By the end of 2024, they see inflation in the U.S. and Europe running from 2.5% to 3.0%.
They worry about a big rupture. “History suggests that tight financial conditions create a high risk of financial accidents and there are areas of vulnerability within markets, such as private credit, commercial real estate and bank loans,” they wrote.
Some still think there’s a hard landing around the corner—a likely plunge into recession. But that much anticipated scenario keeps being eclipsed by higher consumer confidence and employment, which continue to defy expectations. In fact, two of the biggest economic problems are the struggle of companies to find workers and getting home buyers to buy homes.
Increasingly, the business cycle appears to be driven by consumer spending rather than manufacturing, Commonwealth’s McMillan notes. Consumer confidence remains high in the short term, though he notes that Americans are worried about the longer term.
The economy continues to hum, in part it seems because of the massive increase in wealth that began after the Great Recession and continued through the pandemic. A recent Federal Reserve survey found that Americans’ net worth climbed 37% between 2019 and 2022 on the heels of a decade-long bull market in stocks. There is now a huge cohort of baby boomer retirees living it up in the so-called “go-go” years of early retirement.
If Europe and China march into recession in the next 18 months, the U.S. isn’t certain to follow them. Unlike it was in the previous decade, the Fed is now in a position where it has plenty of room to cut interest rates. Moreover, with unemployment under 4.0%, job security ranks near the bottom of most people’s concerns.