November Outlook
November 17, 2023  |  By Hank Cunningham

Inflation remains at the forefront of factors influencing bond yields and while it has receded from its worst levels, it has largely halted its downward progress. Inflation expectations remain in the 3% area. The CPI print on November 14 showed continued improvement but the year-over-year core number is still at 4.00%. Following this print and, in addition to the Fed pause, bonds rallied, pushing the bellwether U.S. 10-year note to 4.45% from 5.00%. Speculation that the Fed would soon begin to lower its Funds rate permeated the market. For its part, the Federal Reserve’s rhetoric throws cold water on this optimism, stating that the inflation fight is far from finished. The Bank of Canada had similar comments.

However, the factors that contributed to the increase in yields before the recent rally are likely to prevent market yields from retracing further. Such factors include the still-resilient economy, although it shows clear signs of slowing, the $2.3 trillion annual borrowing requirement by the U.S. Government, and the Bank of Japan’s move to allow their 10-year bonds to move another 50 basis points higher, towards 1%. This may cause Japanese investors to repatriate some of their foreign holdings, thereby putting upward pressure on bond yields. They own more than $1 trillion worth of U.S. Treasuries.

Also of importance, the recent decline in the inflation rate, combined with the rise in interest rates and bond yields, has produced something not seen in years – positive real yields! The Fed Funds Rate at 5.5%, is now decidedly punitive. Investors can earn a pre-tax real yield and borrowers are incurring a real cost of funds. Inflation expectations have not demonstrated any significant downward movement.

This latest short, sharp rally in the bond market will likely be similar to previous rallies in that it went too far, too fast. The yield curve is still inverted, with two-year yields some 40 basis points higher than 10-year yields. A hot topic in the bond market has become the term: “risk premium” or “term premium.” Simply put, it is common sense that, to invest in a long-term bond, investors should be rewarded with a premium over short-term yields and over inflation. This is not the case right now, which leads to the conclusion that, if/when short-term yields fall, long-term yields may not follow, and could actually rise. Thus, we conclude that yields will not end the year much different than where they are presently. The U.S. 10-year could trade in a range from 4.25% to 5%.

Fixed income investors have earned meager returns this year. As measured by the FTSE Bond Universe Index, year-to-date returns are barely over 1%. Corporate bonds have returned close to 3%. For the remainder of the year, fixed income investors will likely realize positive, but modest returns.

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