With bonds emerging from a historic selloff, investors are cautiously optimistic about the U.S. fixed income market in the coming year, contingent on the Federal Reserve’s expected rate cuts.
A late-year rally in the fourth quarter rescued bonds from an unprecedented third consecutive annual loss in 2023, following the worst decline ever recorded a year earlier.
This resurgence followed a slump in Treasuries to their lowest levels since 2007 in October.
The Morningstar US Core Bond TR USD index, tracking U.S. dollar-denominated securities with maturities exceeding one year, witnessed a year-to-date total return of 5.47% as of this week, a remarkable turnaround from last year’s nearly 13% loss.
This recovery was fueled by the widespread belief that the Fed is likely done with rate hikes and will lower borrowing costs next year.
This view gained momentum when policymakers unexpectedly indicated a 75 basis point easing in their December economic projections, especially as inflation continued to abate.
The prospect of falling rates is expected to drive Treasury yields down and push bond prices higher, a development many investors are eagerly anticipating.
A recent survey by BofA Global Research revealed that investors are holding their most substantial overweight position in bonds since 2009.
However, there are concerns that the path to lower yields may not be smooth.
Some worry that the 100+ basis point drop in Treasury yields since October already accounts for rate cut expectations, potentially leaving markets vulnerable to sharp reversals if the Fed doesn’t act quickly enough.
Market sentiment is pricing in roughly 150 basis points in cuts for the next year, twice what policymakers have suggested, as indicated by futures tied to the Fed’s main policy rate.
Benchmark 10-year Treasury yields stood at 3.87% on Friday, after reaching their lowest level since July earlier in the week.
Furthermore, there is a watchful eye on the potential return of fiscal concerns that drove yields to their 2023 peaks but waned in the latter part of the year.
Despite the anticipation of rate cuts, many recognize that the road ahead could be turbulent.
Brandon Swensen, a senior portfolio manager at RBC Global Asset Management, cautions that it might be a bumpy ride.
Nonetheless, the late-year resurgence in fixed income has boosted fund managers’ confidence, with Vanguard stating, “Bonds are back.”
Vanguard expects U.S. bonds to yield 4.8% to 5.8% over the next decade, compared to the 1.5% to 2.5% expected before the rate-hiking cycle began last year.
The bond market is banking on slowing U.S. economic growth and diminishing inflation to prompt the Fed to lower interest rates.
This development allows fixed income to offer both income and the potential for capital appreciation, according to Eoin Walsh, partner and portfolio manager at TwentyFour Asset Management.
However, some experts believe that certain parts of the Treasury yield curve may have rallied excessively.
Rick Rieder, chief investment officer of global fixed income at BlackRock, noted that both longer-dated and shorter-dated bonds appear “quite rich.”
Concerns about wide fiscal deficits and the anticipation of increased bond supply could elevate term premiums, while demand might lag as the Fed and large foreign buyers like China reduce their holdings of Treasuries.
The recent bond rally has also eased financial conditions, potentially fueling a rebound in growth or inflation, which could delay the Fed’s rate cuts.
The Goldman Sachs Financial Conditions Index has dropped by approximately 150 basis points since late October, standing at its lowest level since August 2022 this week.
Jeremy Schwartz, U.S. economist at Nomura, suggests that as markets increasingly price in rate cuts, the Fed may feel less urgency to implement them since the market is effectively doing the easing for them.
The U.S. fixed income market is poised for potential improvements in 2024, but uncertainty and challenges lie ahead.