US Strategy Weekly: Bonds May Hold the Key

The December rally seems to have run out of momentum early in 2024, and despite three attempts by the S&P 500 index to better its all-time record, it is yet to do so. And while the financial media talks about the market being in record territory, only the Dow Jones Industrial Average managed to eke out a new high recently. Our favorite barometer, the Russell 2000 index, dropped back below the critical 2000 resistance/support level making the bullish December breakout questionable.

Federal Reserve Policy Expectations

There have not been any new developments to stop the advance. However, the December rally was driven by the consensus view that multiple Fed rate cuts were on the horizon and interest rates would begin to fall in March. The new year has tempered these expectations a bit, but we are concerned that those expecting rates to fall at the long end of the curve may also be disappointed. It is not new news that Treasury issuance is expected to nearly double to $2 trillion in 2024. Given this huge increase in supply, prices may have to fall and yields rise to entice demand for this flood of new debt.

It was not long ago that a credit rating downgrade by Fitch fueled a bond selloff that saw the 10-year yield reach 5%, its highest level since 2007. Signs that inflation is stickier than expected could also complicate the supply/demand picture for Treasury issuance. To offset these fears, some economists are theorizing that the central bank may end its quantitative tightening policy earlier than expected in order to improve the supply/demand balance in the marketplace. In the last 18 months, the Fed has reduced its balance sheet by over $1 trillion through quantitative tightening. But some Fed officials, perhaps in response to these fears, recently said the central bank should start considering slowing down and ending the shrinkage of its bond holdings.

Also working against the bond market is the fact that fiscal deficits remain historically high, and the 12-month total deficit was 8% of GDP in December. See page 3. At the end of 2023, the deficit was due in large part to a 7.2% YOY decline in receipts, or government revenues. Revenue declines of this size are worrisome since they represent a decline in income or corporate profits and are usually associated with a recession. In short, this could be a warning for the economy as well as the bond market. It is also worth noting that the current deficit at 8% of GDP is greater than the average 12-month deficit seen prior to the COVID-19 shutdown. Deficits normally run high during recessions but decrease during economic expansions. The fiscal stimulus policies maintained throughout 2023 did boost the economy, as seen in third quarter GDP, but it came at the cost of increasing federal debt to high levels.

The composition of federal debt issuance is directed by the Treasury Secretary, and some have noticed that an increasing portion of debt has been issued at the shorter end of the yield curve, in Treasury bills. This makes sense if interest rates are close to zero, but after Fed tightening lifted short-term interest rates over 5%, this shift has contributed to the problem of rapidly rising interest payments on the debt. Data from the St. Louis Federal Reserve showed that at the end of 2023, government payments on the debt reached 11% of total government outlays. See page 4.

We think some economists believe this rise in government interest outlays may force the Federal Reserve to lower rates earlier than they may want to do so. This may be true, but for that to happen inflation must also fall.  

Economists will be watching every Treasury quarterly refunding announcement in 2024, not only to analyze the supply of debt coming to market but also its composition. The Treasury Borrowing Advisory Committee recommends that short-term financing not be more than 20% of federal debt in order to keep financing manageable. But the 20% level was exceeded in 2020, and at the end of 2023 Treasury bills represented 17% of federal debt and the trend was rising. See page 5. In sum, Treasuries could exceed 20% in coming quarters, and this would increase government interest payments even more. All in all, the bond markets need to be monitored closely this year, since the equity market has already discounted lower interest rates in 2024 not higher interest rates.

Inflation Expectations

The December CPI report showed headline inflation rising from 3.1% to 3.3% in December, with core CPI falling a bit from 4.0% to 3.9%. Our work uses non-seasonally adjusted data, and it shows a slightly different scenario of headline inflation falling 0.1 in December to 3.4% and core CPI increasing 0.1 to 3.9%. But more importantly, most underlying components of the CPI were rising faster than the headline index on a month-to-month basis. See page 6. Overall, most inflation measures show prices decelerating from their 2022 peaks and we think this should continue if energy prices remain stable.

What is a concern is that while headline and core inflation seem to be decelerating, several components of the CPI appear to be rebounding. See page 7. Transportation is the greatest concern for us, but in the service arena, components like motor vehicle insurance are rising 20% YOY. Note, while motor vehicle insurance only has a 2.9% weighting in the index, it is a service that impacts a majority of US households. We think it is items like this, the 5.0% YOY increase in personal care products, or the 5.1% YOY increase in pets, pet products and services, which keep many households concerned about inflation. See page 7.

Technical Update

December’s bullish breakouts in all four of the popular indices were perpendicular and dramatic, but weeks later only the Dow Jones Industrial Average recorded an all-time high. The S&P 500 remains interesting at this juncture since it has been fractionally away from a new record three times in the last month but is yet to better its January 3, 2022 high of 4796.56. The Russell 2000, after beating the key 2000 resistance, has now dropped below this resistance/support level, and this neutralizes the December breakout. See page 9.

The 25-day up/down volume oscillator is at 1.02 and neutral this week after being in overbought territory of 3.0 or higher for 22 of the 25 consecutive trading days ending January 5. This indicator needed to remain in overbought territory for a minimum of five consecutive trading sessions to sanction the advance, which means that the oscillator has confirmed the December uptrend as “significant.” January’s pullback in prices may simply be a short consolidation phase, but it may last longer than some think, since we believe the equity market needs a new catalyst to propel stock prices higher. The obvious catalyst would be better-than-expected earnings, but to date, that has not materialized. As we wrote last week, December’s rally was driven by liquidity, not by valuation. At present, based on the LSEG IBES earnings estimate of $243.51 for this year, equities remain overvalued with a PE of 19.6 times. Adding 19.6 and the inflation rate of 3.4%, sums to 23.0, or just below the 23.8 level that defines an overvalued equity market. Based on the S&P estimate of $241.25; the 2024 PE is 19.8 times and even higher. We remain cautious.

Gail Dudack

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