The Big Idea

Lessons learned from markets in 2023

Steven Abrahams | December 15, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Persistent rate volatility, even after the regional bank crisis and the debt ceiling showdown in the spring, had plenty to teach. The sharp rise in longer rates in the fall packed in a good lesson. Redemptions from mutual funds showed the impact they can have on MBS spreads. And at the tail end of 2023, the competitive advantage private lending may have over bank loans became a little clearer. Every education requires paying a little tuition. This year was no exception.

As liquidity goes, so goes volatility

I thought volatility would die down this year as growth, inflation and the Fed path became clearer. All of these fundamentals definitely have become clearer based on how tightly clustered Street forecasts have become, but rate volatility has stayed high. The missing ingredient and the lesson learned: as liquidity goes, so goes volatility. And with liquidity likely to keep dropping through 2024, volatility should stay surprisingly high.

The rate of new information flowing into the market and the magnitude of surprise is the underpinning for volatility. But liquidity—the supply of investable cash or near-cash—affects how smoothly the market reacts. When liquidity is high, the market can correct even small mispricings and limit volatility. But when liquidity is low, the market swings back and forth across fair value as cash comes off the sidelines in fits and starts.

As liquidity declined this year, volatility rose (Exhibit 1). The lower liquidity showed up in wider dispersion of intraday Treasury yields (Exhibit 1). The New York Fed also saw it in wider bid-ask spreads, lower market depth and a bigger impact for large flows. The lower liquidity made it hard to police mispricings. Option-implied rate volatility rose. And implied volatility, in the short run, is one of the single best predictors of realized volatility.

Exhibit 1: As liquidity has dropped, rate volatility has gone up

Note: The index reflects the average difference in yield between US Treasury issues with a 1-year or longer maturity and the intra-day Bloomberg relative value curve fitter. In liquid markets, deviations go away quickly, and index values are low. In illiquid markets, deviations persist, and index values are high.
Source: Bloomberg, Santander US Capital Markets LLC.

The Fed is likely to keep draining liquidity in 2024 even if it plays to the dots from the December FOMC. QT should keep vacuuming cash out of the financial system, and relatively high rates on repo, T-bills and other instruments should keep a lot of cash trapped in the front end of the yield curve—cash that otherwise would travel to risk assets. A rising price for liquidity should improve relative value in a range of assets:

• In on-the-run rather than off-the-run debt
• In large rather than small issues
• In frequent rather than infrequent issuers

Short rates have a surprising impact on long rates

I came into 2023 expecting a steady series of Fed hikes and expecting short rates to rise much more dramatically than long rates. The 2s10s yield curve would invert by more than 100 bp. And I was right. Twice (Exhibit 2). But I was also wrong in the second half of the year. And the lesson learned in the error is that despite what the textbooks say, short rates can have an outsized impact on long rates.

Exhibit 2: The 2s10s curve broke -100 bp twice but did not stick

Source: Bloomberg, Santander US Capital Markets LLC

The eye-opener on this really came when I tried to formally model fair value in 10-year rates using a list of factors that figure in better known structural models of interest rates:

• Expected inflation
• Expected growth
• Expected rate risk
• Federal deficit
• Fed holdings
• Foreign holdings
• Expected Fed policy

Expected Fed policy turned out to be one of the most reliable influence on 10-year rates. That’s not what the textbooks predict. The textbooks argue for rates as a compensation for inflation, real rates and a term premium. The Fed moves policy around to keep inflation and growth on target, but the policy rate is always supposed to be a temporary influence. The Fed itself still sees the likely long-run policy rate at 2.5% and has seen it that way through the hiking cycle, so longer rates should gravitate into that neighborhood.

Textbooks aside, the 10-year rate approached 5% in October as the market started to price in further Fed hikes, reflecting the impact of Fed expectations on the long end of the curve. Now that fed funds futures expect policy rates to drop by nearly 150 bp in the next year, the 10-year has dropped below 4%. Portfolios holding long duration will ignore shifting Fed expectations at their own risk, regardless of where the Fed may go in the long run.

Liquidity is the Achilles heel of active bond funds and MBS duration

For the second year in a row, active fixed income mutual funds had to deal with outflows after a run of poor returns. As returns on the Bloomberg US Aggregate Index turned negative for the year in August and eventually sank to an annualized loss of 4.26% by mid-October, investors hit the exits. At that low point, active mutual funds in the trailing four weeks had lost more than $19 billion. Maybe this is more of a reminder than a lesson learned, but fixed income funds can magnify spread volatility in these circumstances.

Exhibit 3: Fixed income funds again had to deal with redemptions in 2024

Source: ICI, Bloomberg, Santander US Capital Markets

Having investors in active bond

Having investors leave funds after a poor performance is not really a surprise. That pattern is well established. What was a surprise was the impact on benchmark option-adjusted spreads on par 30-year MBS, which, despite already being at multi-year wides at the start of October widened another 20 bp by the end of October. Of course, as rates rose in October and fund performance fell further, the potential need for cash to fund redemptions made funds into sellers of their most liquid assets—MBS high on the list. Higher rates and wider spreads lengthened the effective duration of MBS, and lower rates and tighter spreads have had the impact in the other direction. Less learned: in a market where active mutual funds have important marginal pricing power, MBS should trade with longer effective duration that models expect.

If private credit wins against bank credit, it will be on speed and flexibility

Finally, the reasons behind the success of private credit in its competition with bank lending, especially since 2016, became a little clearer at the tail end of 2023. Banks have generally lost market share amongst providers of funding to corporate America for most of the last 25 years while corporate bonds and a combination of leveraged loans and other private credit have gained. The leveraged loan and private credit crowd generally explain that they win by being faster, being more flexible or both. But broad and independent confirmation of that had been hard to get until staffers at the Federal Reserve published a new paper in November. Those staffers looked at detailed regulatory filings from 2012 into 2022 on 337,000 loans to 136,000 borrowers. And they found that syndicated lenders seem much more flexible than single banks that make traditional loans to corporate borrowers. The flexibility showed up in dynamic modification of terms throughout the life of a syndicated loan, particularly as the credit conditions of the borrower changed for either better or worse. That tends to support private lenders’ assertion of their competitive advantage. If proposed Basel III Endgame regulations put banks in an even tighter capital box, private lenders may have even more opportunities to exercise those advantages.

* * *

The view in rates

The December FOMC and the dots that show three rate cuts by the end of 2024 have repriced the markets. Fed funds futures now price for between five and six 25 bp cuts by the end of next year, up from the four to five cuts priced just before the FOMC. Rates on 2-year Treasury notes have dropped 28 bp since the day before the FOMC, and rates on 10-year notes have dropped 29 bp.

Other key market levels:

• Fed RRP balances closed Friday at $683 billion, down a sharp $138 billion in the last week as part of a long trend down. Money market funds continue to move cash out of the RRP and into higher-yielding Treasury bills.
• Setting on 3-month term SOFR traded Friday at 536 bp, roughly unchanged again since late August
• Further out the curve, the 2-year note closed Friday at 4.44%, down 28 bp in the last week. The 10-year note closed at 3.91%, down 32 bp in the last week.
• The Treasury yield curve closed Friday afternoon with 2s10s at -53, flatter by 4 bp on the week. The 5s30s closed Friday at 10 bp, steeper by 4 bp.
• Breakeven 10-year inflation traded Friday at 222 bp, roughly unchanged in the last week. The 10-year real rate finished the week at 170 bp, down 30 bp in the last week.

The view in spreads

Despite the December pivot in Fed policy, liquidity is likely to trend lower through 2024 as QT and relative high rates in the front end of the curve continue. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads The Bloomberg investment grade cash corporate bond index OAS closed Friday at 132 bp, tighter by 7 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 146 bp, tighter by 2 bp. Par 30-year MBS TOAS closed Friday at 39 bp, tighter by 1 bp. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, and a Fed pivot next year would soften the impact of higher rates. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.