Special edition: DoubleLine on the yield curve inversion, typical post summer instability, and a new normal in office occupancy

The Great Rate Divide

For much of the post-World War II era, whenever the Federal Reserve began to cut its policy rate, long term interest rates quickly followed suit and saw declines in yields, leading to strong returns across fixed income markets especially in longer duration bonds. With the Federal Reserve expected to start cutting rates this month, a question arises: will longer-term interest rates behave similarly this time?

Fed cuts have typically coincided with periods when the U.S. was heading into or already in a recession. This cycle seems to be different. While U.S. economic data suggests softening growth, the probability of a recession according to Bloomberg economists stands at only 30%.

Secondly, the yield curve has typically been either slightly inverted or flat when the Fed began cutting interest rates, with short- and long-term interest rates aligned. This time around there is a very visible divergence between the level of the Fed’s policy rate and the 10-year U.S. Treasury yield. 

While longer-term treasury bonds have historically been a safe bet for investors anticipating post-rate-cut rallies, today's economic (and inflationary) context paints a more complex picture. The significant yield curve inversion and low odds of a recession complicate the outlook for long term yields unless the U.S. economy deteriorates more than currently expected.

Seasonal Instability

Summer is typically a period when financial markets experience a lull, as many investors and market participants step away from their desks to recharge. This year followed the usual seasonal patterns of low equity volatility until mid-July, when risk assets sold off and volatility surged, reaching a peak in the first week of August. Contributing to this event were weaker than expected economic data such as a disappointing June jobs report, higher than expected initial jobless claims, and a poor reading from the ISM manufacturing PMI, which gauges the strength of the U.S. manufacturing sector. These factors triggered fears the Federal Reserve was ‘behind the curve’ by maintaining a restrictive monetary policy even as the economy softened and inflation cooled.

This rapid unwinding of leveraged positions contributed to the CBOE Volatility Index (VIX), which measures market expectations based on the S&P 500 index options, spiking to an intraday high of 65, a level only seen during the Global Financial Crisis and the start of the pandemic in March of 2020.

August and September Typically Perform Poorly

Seasonal analysis of S&P 500 monthly performance shows that equities tend to sell-off in August and September. On average, the S&P 500 is down a cumulative -1.5% in August and September.

Interestingly, the August/September instability in equities may set the stage for stability in the following months. Since 1990, the period from October through December has consistently been the strongest period for stock performance with average monthly returns of +1.7% (+20.1% annualized). Equity volatility typically peaks around late September, and drifts lower in the fourth quarter. Enjoy the rest of summer, but keep in mind that September can be a turbulent month. But do not fret as the turbulence is usually short-lived.  

A ‘New Normal’ in Office Occupancy

This chart shows the average office occupancy for the top ten cities tracked by Kastle Systems, a provider of office building security solutions. Based on daily security key card swipes at office buildings across the country, office use today is less than half of the pre-pandemic level.

Strikingly, there has been slight increase in office usage over the past year, which is well past the pandemic era, implying that we may have reached a new equilibrium in how American businesses utilize office space. Of the ten cities tracked by Kastle, the Austin metro area has the highest office usage at 60.6% of the pre-pandemic baseline while San Jose metro area has the lowest at 40.3%. A notable feature for both metros is that like the nationwide numbers, office usage is unchanged compared to 2023.

BOJ Outpaces Fed at Bond Buying

Today the Federal Reserve holds $4.45 trillion U.S. Treasuries on its balance sheet, a whopping 550% increase over the past 20-years. While this may sound like a stark increase, and it is, the Fed’s holdings of U.S. Treasuries have not kept up pace with the increase of U.S. Treasury debt outstanding which has surged more than sixfold during the same period. Of the $27 trillion of marketable U.S. Treasury debt outstanding, the Fed now holds nearly 17%, down from the 25% peak reached at the end of 2021, and surprisingly to most, in line with the pre-global financial crisis (GFC, 2002-2007 average) era.

This chart highlights the divergence of Fed and Bank of Japan (BOJ) policies as it relates to government debt purchases. Up until 10 years ago, the Fed held a larger share of government debt outstanding, but that flipped in July 2014.

What has been the cost of such extreme monetary policies and indirect monetization of government debt in Japan? Since peaking in 2011, the Japanese yen has depreciated over 50% vs. the USD. In gold terms, the value of yen is down 68% over the same period. Shockingly, inflation in Japan has averaged less than 1% over this period, indicative of the structural deflationary forces at play.

From Surge to Stability

This chart shows the number of consecutive months when the headline CPI YoY inflation rate has been 3.0% (rounded to the nearest 0.1%) or higher. The recent streak of over 3% ended in July, marking a 39-month battle with inflation. As the chart shows, the recent streak was the fourth longest in the U.S. since World War II. The U.S. has not seen a series of high inflation prints like this since the early 1990s. Amazingly, since the streak started in April 2021, CPI is up 18.2%.

In a more benign inflation regime, such as the one we experienced between October 1991 to March 2021, the average inflation rate was 2.2%, and bonds performed well as interest rates declined. This time might very well be no exception. If U.S. inflation continues to cool as expected in the coming months, this should give the Fed continued confidence to initiate its well-anticipated policy-rate cutting cycle. History suggests that the U.S. Treasury yield curve tends to steepen as front-end yields decline more than long-end yields, and Treasuries tend to perform well overall during policy-rate cutting cycles.