Key takeaways
After trending higher earlier in the year, 10-year U.S. Treasury yields have reversed course.
Yields on the benchmark 10-year U.S. Treasury moved as high as 4.70% in April but shed nearly 1% from this peak by September.
Investors may want to reexamine the role bonds play in their diversified portfolios considering current interest rate dynamics.
The interest rate environment continues to undergo significant transformation, defined by falling bond yields. Investors anticipated Federal Reserve (Fed) interest rate cuts in 2024, which finally occurred in mid-September. This reaffirmed investor sentiment, and anticipation that in the months ahead, declining bond yields are likely.
This comes after a more than two-year period when interest rates (based on the benchmark 10-year U.S. Treasury note) rose to their highest level since 2007.1 Bond markets followed the Fed’s lead, as central bankers boosted the federal funds target rate it sets to guide what banks charge each other for overnight loans. From early 2022 to July 2023, the Fed raised the fed funds target rate from near 0% to a to level of 5.50%. Its primary mission was to temper what had been rising inflation. The Fed held rates at that level until September 2024, when the policymaking Federal Open Market Committee (FOMC) initiated a 0.50% fed funds rate cut, its first cut since 2020.
Bond investors are always closely attuned to the Fed’s actions and signals of future actions. In April 2024, as inflation remained elevated and it became clear the Fed would continue to delay initiating rate cuts, the 10-year Treasury yield peaked at 4.70%.1 By September, the yield on the 10-year Treasury dropped nearly 1% below April’s peak.
After spending the first half of the year in negative territory, over the summer, bond market total returns shifted into positive territory. Investors benefited from the bond value increases that occur when yields decline. Near the end of September, the Bloomberg U.S. Aggregate Bond Index was up 4.65% year-to-date.2
“Ultimately, declining yields on the long end of the bond market reflect long-term inflation and economic growth expectations,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The short end of the yield curve is more directly anchored to the Fed’s stance on the fed funds rate.”
While the Fed seeks to maintain low inflation and maximum employment, in the last 2+ years, the Fed primarily focused on its inflation mandate. It became apparent in recent months that Fed policymakers were more confident about winning the fight against inflation, and its focus shifted to the labor market.
“In the labor market, conditions have continued to cool,” said Fed Chair Jerome Powell following the Fed’s September interest-rate cutting decision. “Payroll job gains averaged 116,000 per month over the past three months, a notable stepdown from the pace seen earlier in the year.”3 Powell noted that conditions in the labor market appear to be “less tight” than in 2019, just prior to the COVID-19 pandemic’s start.
In August, the unemployment rate stood at 4.2%, modestly lower than July’s 4.3% reading. The July figure represented the highest unemployment rate since October 2021.4 With clear signs that inflation is easing amid concerns of a slowing economy, bond yields retreated throughout the summer.
What should investors expect from the bond market and Fed interest rate policy as 2024 winds down and 2025 approaches? What does that say about how to incorporate or adjust strategies for fixed-income investors?
The Fed is trying to find a sweet spot, driving inflation lower without slowing the economy to the point that it causes a recession. So far, the Fed has achieved this so-called “soft landing” for the economy, but the Fed continues to walk an economic tightrope. “The overriding pressures on Treasury yields are the Fed, Treasury supply and then growth and inflation,” says Tom Hainlin, senior investment strategist, U.S. Bank Wealth Management.
To this point, the economy continues on a positive track. Second quarter 2024 economic growth as measured by Gross Domestic Product (GDP), was 3.0% (annualized rate), more than double its first quarter level. That’s lower than 2023’s final two quarters, which registered annualized GDP gains of 4.9% (third quarter) and 3.4% (4th quarter).5 After its September meeting, Fed officials issued projections of 2.0% 2024 GDP growth, with a similar expectation for 2025. The Fed projection indicates slightly slower economic growth going forward.6
Before September’s Federal Open Market Committee (FOMC) meeting, investors anticipated a 0.50% rate cut, and the FOMC met expectations. The next meeting of the FOMC is November 6-7, 2024. To this point, investors fully expect another rate cut, but expectations of the size of that cut vary.7
The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on the shortest-term bonds exceeding those of some longer-term bonds. This inverted yield curve emerged in late 2022. Under normal circumstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. As of September 23, 2024, 3-month Treasury bills yielded 4.72% and 2-year Treasury yields were 3.57%, compared to the 3.75% yield on the 10-year Treasury. 2-year yields had been higher than 10-year yields since 2022, but in early September, 2-year yields slipped below 10-year yields and remained in that position.1
Over the year, bond yields declined significantly but remain notably higher than was the case at the start of 2022. Bill Merz, head of capital markets research at U.S. Bank Wealth Management, says three key factors are at play. “First is the Fed’s policy response to inflation. Second is the strength of the U.S. economy. Finally, an increasing supply of U.S. Treasury securities are coming to the market.”
“New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.
“Ultimately, declining yields on the long end of the bond market reflect long-term inflation and economic growth expectations,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The short end of the yield curve is more directly anchored to the Fed’s stance on the fed funds rate.”
As of June 1, the Fed began scaling back its bond reduction program. The Fed reduced its redemption of U.S. Treasury securities from $60 billion per month to $25 billion per month.8 “This change signals that the Fed is somewhat comfortable maintaining a higher balance sheet of bond assets,” says Haworth. The Fed currently holds $7.1 trillion in assets, down from a peak of nearly $9 trillion reached in early 2022, but much higher than the less than $4 trillion in assets it held in September 2019.9
How should investors approach fixed income markets today? With inflation lower and concerns about the potential for a slowing economy, investors may wish to consider a neutral-to-underweight fixed income position within portfolios that mix stocks, bonds and real assets.
Investors may want to take advantage of specific bond market opportunities, taking into account their risk tolerance and tax situation. For example, investors in high tax brackets may benefit by extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Some non-taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. They can also incorporate long-maturity U.S. Treasury securities to manage total portfolio duration. And, for certain eligible investors, insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors.
Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.
The bond market is often reflective of other key factors that affect the economy. If the economy grows rapidly and inflation is rising, bond yields tend to follow suit. Bond yields also tend to rise if the Federal Reserve, the nation’s central bank, raises the short-term interest rate it controls, the federal funds target rate. Inflation in the U.S. began surging in 2021, and by early 2022, the Federal Reserve began raising rates. As a result, yields across the bond market began rising. In contrast, if the economy is slowing or maintaining modest growth with low inflation, bond yields tend to decline or remain low. This was the situation for an extended period prior to 2022. In mid-2024, bond yields began to decline again, and, in September 2024, for the first time since 2020, the Fed cut short-term rates by 0.50%.
Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond’s price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates. Bondholders will generally be repaid the face value of a bond if it is held to maturity, regardless of the interest rate environment.
There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels. However, even when interest rates are low, bonds can still be appropriate for inclusion in a well-diversified portfolio.
As interest rates change, learn what the ripple effects across capital markets may mean for investors.
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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