Dagmara Fijalkowski: What is your outlook for fixed income markets for 2024?

With yields higher over the past quarter, I'm often asked if it's time to invest in bonds. We can approach this question by looking at valuation and simply answer if we are getting paid for the risk taken. The framework for a valuation of U.S. ten-year treasuries, which are a cornerstone of pricing in capital markets, is relatively simple.

Yield should compensate investors for real rates, inflation expectations and term premium. Now, between July and October, yields on ten-year treasuries shot up by more than 100 basis points. We believe the drivers were at term premium and real rates. Real rates have gone up in response to much stronger growth in Q3 than in the first half of the year.

And in response to resilience of the economy to 525 basis points of rate hikes. There has been a lot of speculation about r-star potentially shifting higher from historic estimates of about 0.5%. Long term estimates have been between 0.5% and 1%. Term premium increase reflected deterioration of the fiscal situation in the U.S., which was even more troubling because estimated budget deficit in 2023 was twice the size of 2022, and that's in absence of a recession.

As a result, of course, investors expect increased debt issuance. And the other driver of higher term premium is lower demand from foreigners for U.S. treasuries. Lower demand because local rates for foreigners in Europe and Japan have increased and on a relative basis are slightly more attractive than they were before. Chinese have been intervening in the foreign exchange  (FX)  (2:17) market by selling their stock of U.S. Treasuries.

And of course, all the foreign reserve holders have noted their freezing of Russian reserves after the invasion of Ukraine, which means that the marginal utility of reserves for reserve holders has fallen, and they have been selling U.S. treasuries. So as a result of foreigners stepping back, the marginal buyer of debt is now private, and they demand higher yields to compensate for risk.

You can say bond vigilantes are back. If we add up an estimate of r-star real growth of 0.5%, inflation compensation of 2%, and term premiums of 0.5%, the fair value of 10-year Treasury in the U.S. is 3%, let's say 3%, 3.5%. By the end of October, yields reached 5% and that brought buyers in droves (2:25).

November has seen a powerful bond rally. Growth slowed a little, there were no further negative fiscal surprises and inflation numbers have been coming down. As we near year end, our expectations for 2024 are leaning towards slower growth, more constraints on deficit spending, and falling inflation, all of which should guide bond yields lower.

Dan Mitchell: What is your outlook for the U.S. dollar in 2024?

We've had a negative outlook on the US dollar for some time. And while the currency has declined by about 8% since its trade weighted highs last year, it hasn't fallen by as much as we had expected. That's largely because U.S. interest rates have risen by more than in other regions, and the higher yield is sort of propping up the currency.

But as we look forward to 2024, we see mounting headwinds for the currency. Increased the odds of a US recession next year, Federal Reserve cuts that should take away some of that yield support and an increasing focus by the market on unsustainable fiscal deficits. Already we've seen some of the world's major developed market currencies regain their footing with the euro, the Japanese yen and the Chinese renminbi, each rallying by 3% in November.

Recent strength in gold, in silver and cryptocurrencies also sort of supports that theme of a shift in sentiment away from the U.S. dollar. But before any meaningful decline in the U.S. dollar to materialize, investors really need to see improved economic prospects in the rest of the world. That's what's going to draw that capital shift away from the U.S. and weaken the currency.

So far that hasn't happened, but we feel the market may be too pessimistic on Europe and China here, and we expect that that economic improvement might happen in 2024. Altogether, we expect the U.S. dollar to weaken by about 10% next year, with major development market currencies benefiting most and emerging market currencies following once the U.S. dollar sell off gained steam.