After a strong first half of the year, financial markets took a breather in the third quarter as restrictive monetary policy, combined with a still-robust economy, put upward pressure on bond yields and downward pressure on stock prices. The S&P 500 had a total return of -3.3% while the yield on the 10-year treasury surged from 3.8% to 4.6%. Higher yields resulted in lower bond prices, with investment-grade bonds falling 3.2% as measured by the Bloomberg U.S. Aggregate Bond Index.
As inflation continues to recede, the Federal Reserve has slowed its pace of rate hikes, opting to pause again during its meeting in September after raising the federal funds rate by 25bps in July. The target range now stands at 5.25-5.50%, with the midpoint being the highest level for the benchmark rate since 2001. Investor attention is now focused not so much on how high the rate will peak, but for how long it will remain elevated. This was evident in September when the Fed projected that the fed-funds rate would remain near its current level throughout 2024 due to stronger than anticipated economic data, causing a selloff in bonds. The market’s reaction to higher-for-longer interest rates helped push the yield on the 10-year treasury to a level not seen since 2007.
While monetary policy and the strength of the economy play a significant role in the rise in bond yields, fiscal policy is beginning to have an impact as well. Specifically, an increase in debt issuance by the U.S. Treasury, concerns surrounding larger federal budget deficits, and higher U.S. debt-service costs have all contributed to the upward pressure on longer-dated yields. Such factors were cited by a major credit rating agency in early August when it downgraded U.S. debt from AAA to AA+.
An important aspect of the current investment environment is that bonds are now becoming a more attractive option for income-focused investors compared to the last decade. After the 2008-09 financial crisis, investors searching for yield were drawn to dividend-paying stocks as near-zero interest rates and quantitative easing pushed bond yields to historical lows. Today’s interest rate regime is changing the landscape, with fixed income now becoming a viable alternative. The impact of this shift became clear during the quarter when Utilities and Real Estate stocks, often considered bond proxies due to their generous dividend payouts, significantly underperformed the broader market as yields surged higher.
Megacap technology stocks, which drove the equity rally during the first half of the year, had mixed performance during the quarter. The enthusiasm toward artificial intelligence, while still a major theme this year, has become less pronounced. We’re still paying close attention to the narrow leadership the S&P 500 is exhibiting. With megacap technology companies making up over 25% of the index, the group’s performance will continue to have an outsized effect on the overall market.
As we head into the fourth quarter, there are a multitude of factors influencing both financial markets and the broader economy. Our focus continues to remain on the impact of higher-for-longer interest rates, the resiliency of consumer spending, the strength of the labor market, and the trajectory of inflation. We’re also being mindful of more recent events, including political standoffs surrounding the U.S. budget and rising geopolitical risks.
As always, please do not hesitate to reach out to us with any questions.