Key Updates on the Economy & Markets
Financial markets underwent a sizeable shift in the fourth quarter. Treasury yields, which spiked in Q3, reversed lower as inflation eased and the Federal Reserve hinted at interest rate cuts in 2024. The decline in interest rates was a significant tailwind for stocks and bonds. The S&P 500 gained +11.6% during the quarter, and bonds produced their best quarterly return since Q2 1989. This letter recaps the fourth quarter, discusses the decline in Treasury yields and the potential for interest rate cuts, and looks ahead to 2024.
Treasury Yields Reverse Lower in Fourth Quarter
Following a significant increase in Q3, Treasury yields moved sharply lower in Q4. Figure 1, which compares the change in yields during the two quarters, graphs the opposing interest rate moves. The gray bars show yields increased in Q3, with longer maturity yields rising the most. In contrast, the navy bars show yields reversed sharply in Q4, erasing nearly all their Q3 rise. The abrupt reversal can be attributed to a significant change in the market’s view heading into 2024.
Investors had two key concerns, both of which contributed to the rise in Treasury yields during Q3. First, the U.S. economy continued to outperform expectations, which raised concerns that the Federal Reserve might need to keep interest rates high for an extended period to cool inflation. Second, the fiscal deficit was growing quickly as government spending increased. Investors were concerned the U.S. Treasury would need to issue a large amount of new debt to finance the growing deficit but that there wouldn’t be enough buyers for the new bonds, potentially causing yields to rise if supply outweighed demand.
A notable shift occurred in November, setting off a sharp reversal in Treasury yields. Investor worries about increased Treasury bond issuance were alleviated as the U.S. Treasury revealed plans to slowly increase bond issuance. The market felt there would be enough demand to absorb the new bonds, lowering the probability that too much bond supply would cause yields to rise. In addition, data showed that inflation continued to decline even as the economy continued to exceed expectations. Investors’ fears about persistent inflation and high interest rates faded from view, and yields declined.
With Inflation Falling, Market Expects Rate Cuts
Data shows that inflation pressures continue to ease. Figure 2 graphs the year-over-year change in headline and core inflation. Headline inflation, which peaked at 9.1% in June 2022, dropped to 3.1% in November 2023. Likewise, core inflation, which excludes the volatile categories of food and energy, now stands at 4.0% after peaking at 6.6% in September 2022. The price declines have been widespread across categories, with price pressures easing across food, energy, airfares, and household furnishings and appliances.
S&P 500 Registers its Biggest Monthly Gain Since July 2022
Monthly Market Summary
Stocks Trade Higher as Treasury Yields Reverse Lower
The big story during November was the decline in Treasury yields. The bond market experienced large moves in interest rates, with the 10-year Treasury yield falling to 4.36% from over 5% in October. For context, the -0.54% decline in the 10-year yield ranks among the biggest 1-month drops since December 2008, when the Federal Reserve cut interest rates by -0.75%. Falling Treasury yields provided relief to bonds, which have traded lower as the Federal Reserve hikes rates. The Bloomberg U.S. Bond Aggregate Index, which tracks a broad index of U.S. bonds, produced a +4.6% total return. It was the index’s first gain in seven months and its biggest gain since 1985.
The decline in yields helped the stock market rebound after trading lower for three consecutive months. The S&P 500 recorded its biggest monthly gain since July 2022 and currently trades less than 5% below its all-time closing high. The NASDAQ 100 Index gained +10.8% as mega-cap growth stocks such as Microsoft, Apple, and NVIDIA traded toward new all-time highs. Technology was the top-performing S&P 500 sector as the rally in growth stocks propelled the sector to a new all-time high. Real Estate followed close behind, benefiting from falling interest rates that provided relief to property owners. Defensive sectors, including Consumer Staples, Utilities, and Health Care, lagged as the market traded higher.
Stocks & Bonds Trade Lower as Interest Rates Continue to Rise
Monthly Market Summary
Stocks Decline for a Third Month as Rates Reach Highest Levels Since 2007
The S&P 500 gained more than 20% through the end of July but has since declined 8.3% over the past three months, bringing its year-to-date gain to 10.6%. A significant factor behind the recent equity market sell-off has been the sharp rise in interest rates, with the 10-year U.S. Treasury yield climbing +1.25% from mid-July through mid-October and rising above 5% for the first time since 2007. This surge in Treasury yields continues to weigh on both stocks and bonds as valuations adjust to a world of higher interest rates. Small-cap stocks underperformed large-cap stocks by over -4.5% in October, and defensive sectors outperformed cyclical sectors. In the credit market, bonds posted another month of negative returns. The following paragraphs discuss why stocks and bonds tend to experience pressure during rising rate periods.