The US Treasury market saw historic volatility in 2023 as uncertainty around inflation and Fed policy resulted in the benchmark 10yr to trade in a wide range from 3.30% to 5%. The Federal Reserve delivered 4 rate hikes of 25bps in 2023, the last of which came at the end of July taking Fed Funds to the 5.25%-5.50% bound, the highest level in almost 25 years.
After the sharp rally in US Treasuries to close Q1, spurred by the Silicon Valley and Signature Bank failures, the Rates market endured 6 straight months of selling. By Autumn, sentiment around bonds had soured dramatically, especially on the long-end. Concerns over heightened supply amidst record government debt levels across the developed World and a US Federal deficit pushing $2 trillion dominated the Rates market. The 10yr breached the 5% level in mid-October and the 2yr closed above 5.20%. 2023 was shaping up to be a lackluster year for fixed income after the carnage of 2022.
This changed, however, after a benign inflation report and dovish Fed commentary turned the Rates market on a dime in late October. 5% was seemingly the magic number to bring in buyers in force and quell the so-called “bond vigilantes”. November saw the Bloomberg US Aggregate Bond Index return 4.53%, its best month since May of 1985! Further, the Fed’s last FOMC meeting of the year in mid-December cemented the “Fed pivot” narrative as Chair Powell emphasized the restrictive nature of current overnight rates and the downward trend of inflation. Markets went from the possibility of an additional 25bp hike in the Fall to pricing in several cuts in 2024. The Q4 rally took the 2yr and 10yr yield down 97bps and 112bps, respectively, from the October highs to close the year at 4.25% and 3.88%, remarkably close to where they began 2023.
2023 was indeed a rollercoaster ride for fixed income investors, but the sharp rally in Q4 allowed bonds to post solid returns. Intermediate US Treasuries returned 4.3% for the year and Investment Grade debt notched an 8.4% gain as spreads tightened with the “everything rally” in Q4. Cash remained a good place to be as well, returning over 5%.
At Meritage, we avoided most of the pain of the drawdown in bond prices in Q3 and into Q4. We also benefited nicely from the Rates rally and corporate spread tightening to close the year, however longer-duration portfolios of course outperformed. We are currently extending duration in Intermediate bond portfolios towards neutral, but are hesitant to do so aggressively given the sharpness of the Rates rally and murky picture on how quickly the Fed can return inflation to its 2% target, on top of a still inverted yield curve. Although we agree that this Fed hiking cycle has likely come to an end, record Government debt and trillion+ deficits remain a risk to long-duration bonds we cannot ignore.
Both our Short Duration and Intermediate strategies focus on short-dated bonds for corporate exposure to maintain strong liquidity while picking up yield. We continue to favor US Treasuries and Corporates over Municipal debt, but stand ready to add tax-exempt exposure when we believe yields are high enough to compensate for the lower liquidity. We expect uncertainty to remain high in fixed income markets as the inflation/disinflation story plays out in 2024, but take comfort in a still substantial yield buffer on the front-end where we don’t have to depend on Fed cuts for positive returns.
