Key takeaways

  • Bond yields are significantly higher today than has been the case in recent years.

  • After topping 4% in early March 2023, the yield on 10-year Treasury notes dropped significantly in the immediate aftermath of high-profile bank failures.

  • An unusual “yield inversion” remains in place, with 3-month Treasury bills paying a higher interest rate than 10-year Treasury notes.

Investors continue recalibrating in light of unusual bond market dynamics. To illustrate the fluidity of the market, consider what’s happened with the benchmark 10-year U.S. Treasury note dating back to the end of 2021. At that time, it yielded just 1.5%, reflecting a longstanding trend of lower interest rates. The yield then rose dramatically in 2022, peaking at more than 4% in October, a level not reached since April 2010.1 It has undergone significant fluctuation since that time. Most recently, after topping 4% again in early March 2023, the 10-year Treasury yield dropped significantly in a matter of days as markets reacted to news of bank failures.

The collapse of Silicon Valley Bank and Signature Bank, two high-profile regional banks, raised investor concerns. The U.S. government and Federal Reserve quickly moved to assure Americans that bank deposits were safe. Nevertheless, equities lost ground in the immediate aftermath as investors sought the relative safety of Treasury bonds. With demand for bonds quickly spiking, interest rates dropped rapidly in mid-March 2023, shifting the environment yet again for fixed income investors.

Given these recent developments and the broader economic environment, what should bond investors expect going forward? Have secular market trends been altered by recent developments?


Changing environment for bond investors

While short-term events can temporarily affect the bond market, interest rates tend to follow long-term growth and inflation trends. Higher inflation often results in higher interest rates. Persistently elevated inflation altered the landscape for bond investors in 2022. Factors that affected the bond market included continued supply constraints for goods, a major shift in monetary policy by the Federal Reserve (the Fed) and Russia’s invasion of Ukraine.

The result was an inflation surge from early 2021 through mid-2022. The Consumer Price Index (CPI) peaked at a level of 9.1% for the 12-month period ending in June, its highest reading since 1981.2 It has since declined, standing at 6.0% for the 12-month period ending in February 2023.

“Bond yields rose primarily because the Fed pivoted to a much more hawkish position, as investors anticipated aggressive interest rate hikes to rein in inflation,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. Merz notes that bond markets tend to move in advance of specific Fed actions, often anticipating upcoming monetary policy moves.

Rising bond prices work against existing bond holders because of the inverse relationship between bond yields and bond prices. When yields rise, prices of current bond issues fall. This is a function of supply and demand. When demand for bonds declines, issuers of new bonds must offer higher yields to attract buyers, reducing the value of lower-yielding bonds already on the market. This environment hit bondholders hard in 2022 and again in early 2023.


Fed’s influence on interest rates

The Fed uses interest rate hikes on the short-term federal funds rate it controls as a tool to raise borrowing costs to slow economic activity and dampen inflation. Fed Chairman Jerome Powell and other members of the policy-making Federal Open Market Committee (FOMC) made clear that the Fed’s “easy money” policies from 2020-21, which included maintaining a near 0% federal funds target rate (a short-term interest rate the Fed controls), had to change in response to rising inflation.

“Our emphasis is on high-quality investment-grade taxable and municipal bonds to manage overall portfolio risk exposure should the economy continue to slow.”

Bill Merz, head of capital markets research at U.S. Bank Wealth Management

The Fed pursued an aggressive interest rate policy, and by February 2023 had raised the fed funds rate by 4.50%, a significant turn of events. Powell indicated that the Fed may become less assertive going forward, but also stated that, “Despite some promising developments, we have a long way to go in restoring price stability.”3 According to Merz, Powell is clearly looking for more convincing evidence of a sustainable inflation slowdown.

In early March, Powell reiterated this theme, saying that “the latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”4

Powell’s comments temporarily raised the possibility of the Fed pushing rates higher than previously expected. “That made the market more volatile in the wake of Chair Powell’s comments,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The market is trying to determine the terminal federal funds rate (its peak level) in 2023, and that’s still a little hard to predict.”

In early March 2023, yields on U.S. Treasury securities stood at or near the highest levels seen in years. However, in just a matter of days, as issues emerged about troubled banks, investor sentiment changed. Many investors fled into the relative security of Treasury bonds. The result was a significant drop in bond yields.

Graph depicts the 5-day drop in bond yields between March 8, 2023 and March 13, 2023.


Inverted yield curve persists

Despite recent upheaval in the interest rate environment, one trend that remains is the unusual shape of the yield curve representing different bond maturities. Under normal circumstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve. It logically reflects the thinking that investors should earn a return premium for the greater uncertainty inherent in lending money over a longer time period. The current environment is unusual, as yields along the maturity spectrum now reflect an inverted curve.


U.S. Treasury Yield Curve Comparison
Dec. 31, 2021 and Mar. 13, 20231

Graph depicts a normal yield curve at the end of 2021 (represented by the blue line) as compared to the inverted yield curve (represented by the red line) that exists as of March 13, 2023. The graph plots the relative yields of 3-month, 2-year, 5-year, 10-year and 30-year U.S. Treasury securities.

The curve is generally downward sloping today, compared to the normal upward sloping curve. Most notable is the inversion between 3-month and 10-year Treasury yields, which became more pronounced in recent months. A common view of many analysts is that such a yield curve inversion signals increased odds of a recession in the future. “The deeper inversion lately may be a sign that the markets anticipate a more prolonged slowdown in the economy,” says Haworth. “For corporate borrowers, the cost of capital is going up, increasing the required rate of return for successful projects or investments.”


How far will the Fed raise interest rates?

After year-over-year inflation peaked in June 2022, inflation has trended lower, but even at the level of 6.0% for the 12-months ending in February 2023, remains well above the Fed’s target inflation rate of 2% annually.2 “Decelerating year-over-year inflation is constructive,” says Merz, “but we need to see much more before the Fed may change its policy approach.”

Merz also notes that there’s a lag time between when the Fed puts interest rate policy into place and its impact on the broader economy. “Many economists believe the impact is felt 12-18 months after a change in interest rate policy, though some believe that lag is shorter,” says Merz. He expects inflation to continue decelerating but remain sufficiently elevated that it results in pressure on the Fed to maintain higher interest rates.

At the same time, recent challenges in the banking sector make some question whether the Fed has done too much damage. “There’s an old saying that the Fed keeps hiking interest rates until something breaks,” says Haworth. “But the Fed’s work is not done, given how far we are from its 2% target inflation rate. It hasn’t yet succeeded in breaking the inflation threat.”

External events can also impact inflation trends. A prime example in the current environment is the Russian invasion of Ukraine. Russia is a major energy producer, particularly for Europe, while both countries are significant agricultural exporters. The conflict has affected the flow of oil, natural gas and food products. With supplies reduced, oil consumers push prices higher. “That’s outside the control of central banks,” says Merz. “Interest rate hikes by the Fed, the European Central Banks and others are meant to slow demand, but they don’t improve supply.”

An economic slowdown could also alter the general upward trend of interest rates. Despite recent events and the Fed’s ongoing efforts to slow economic growth, Haworth says a recession does not appear imminent. “Much of the underlying economic data remains solid, but we’ll have to see if consumers begin to pull back on spending.” To this point, consumer spending has helped keep the economy moving in a positive direction.

Yields on bonds in the broader market can also be affected by supply and demand issues. With the Fed dropping out as a buyer of Treasury bonds and mortgage-backed securities, other buyers have to step up. “The private market and foreign buyers must absorb the supply of Treasury securities the Fed is no longer buying,” says Haworth. To this point, there are limited liquidity issues in the U.S. Treasury market, but if that becomes a problem, it could drive interest rates higher. Haworth is watching the direction of the federal government’s budget deficit. “If deficits move lower, the market likely has capacity to absorb new bond offerings,” says Haworth. “But if deficits move higher, it may become more of a challenge.”


Finding opportunity in the bond market

What are the best options for bond investors in today’s market? “In light of the recent drop in bond yields, there’s more risk in the bond market today than existed prior to that decline,” says Haworth. “If we assume that the Federal Reserve will continue to push interest rates higher, even in a more cautious manner, then there is a risk that rates in the broader bond market will rise again.”

As market risks rise, investors may want to focus on safety and quality. “We’re putting greater emphasis on core bond holdings,” says Merz. “We believe that bonds offer compelling defensive characteristics relative to stocks.” Specifically, he recommends both taxable bonds and, where appropriate, tax-exempt municipal bonds. “Our emphasis is on high-quality investment-grade taxable as well as a dedicated exposure to short-term U.S. Treasury investments to manage overall risk exposure should interest rates continue to rise in the near term,” says Merz. Within certain tax-aware portfolios, a modest allocation to high-yield municipal bonds is also an option to consider for some investors.

There is an important potential benefit for bond investors who concentrate more of their bond positions in high-quality segments of the fixed income market. “This is a way to add diversification to help manage risks in a portfolio that includes equities,” says Merz. While a rarity occurred in 2022 as both stocks and bonds declined in value, Merz believes that over the long run, holding high-quality bonds will typically help smooth volatility in an investor’s diversified portfolio.

Haworth suggests starting with short-term bonds that may offer more protection for fixed income investors than longer duration bonds given the current uncertainty surrounding the yield curve and direction of interest rates.

Additionally, investors may wish to consider other aspects of the fixed income market that offer unique potential. For example, there is an opportunity with securitized bonds, including non-government agency issued residential mortgage-backed securities, which offer the potential to enhance income and diversify a portfolio of Treasury securities.

According to Merz, “This remains a time when investors are likely to benefit from holding more high-quality assets and fewer volatile assets than in a typical period.”

Talk to your wealth professional for more information about how to position fixed income investments as part of a diversified portfolio.

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  1. U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates.

  2. Source: U.S. Bureau of Labor Statistics.

  3. Cox, Jeff, “Fed Chair Powell says smaller interest rate hikes could start in December,”, Nov. 30, 2022.

  4. Federal Reserve Board of Governors, “Semiannual Monetary Policy Report to the Congress,” by Chair Jerome Powell, March 7, 2023.

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