Key takeaways
U.S. Treasury yields have trended higher for much of 2024, until a recent pullback.
Yields on the benchmark 10-year U.S. Treasury moved as high as 4.70% in April, but by July retreated to below 4.20%.
Investors may want to reexamine the role bonds play in their diversified portfolios given today’s persistent inflation.
Yields on the 10-year Treasury began 2024 below 4%, but steadily rose until reaching a peak of 4.70% in April. Because bond values decline when yields rise, bond total returns were mostly in negative territory over the year’s first half. However, yields have retreated since the spring, ultimately falling to as low as 4.16% on the 10-year Treasury by mid-July.1 Rates hover near 4.20% as the month ends. With yields declining, bond markets moved into modestly positive territory year-to-date in July, based on the Bloomberg U.S. Aggregate Bond Index.2
Bond investors are closely monitoring Federal Reserve (Fed) interest rate policy. After raising rates dramatically over a 16-month period ending in July 2023, the Fed has held the line on the short-term federal funds target rate it controls. However, investors appear to be anticipating that the Fed is likely to reverse its interest rate policy and begin cutting rates, perhaps as early as September 2024. This boosted investors’ appetite for bonds, helping drive long-term interest rates lower.
“Declining yields on the long end of the bond market reflect waning investor concern about inflation,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The short end of the yield curve has mostly held steady, an indication that the market remains concerned about long-term growth risks.” A primary focus for investors is Fed monetary policy. Recent comments by Fed Chair Jerome Powell were considered an encouraging sign about the prospects for rate cuts in the near future. Powell indicated that the Fed wants to feel confident that inflation is moving toward its 2% target before rate cuts begin. A primary inflation measure, the Consumer Price Index (CPI) stood at 3.0% for the 12-months ending in June.3 That prompted Powell to say “we didn’t gain any additional confidence (about easing inflation) in the first quarter, but the three (inflation) readings in the second quarter….do add somewhat to confidence.”4
What should investors expect from the bond market for the remainder of the year and 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.
First quarter 2024 economic growth, as measured by Gross Domestic Product (GDP), was 1.4% (annualized rate). That’s significantly softer than 2023’s final two quarters, which registered annualized GDP gains of 4.9% (third quarter) and 3.4% (4th quarter).5
“There are signs that the economy is slowing enough that the Fed will want to consider rate cuts,” says Haworth. “Even if inflation is not yet down to the Fed’s target 2% rate, we’re not seeing any signs that it is accelerating either. Given those expectations, there’s little risk that long-term bond yields will rise dramatically from current levels.”
However, investors can expect that yields will fluctuate in a modest range, at least in the near term, as markets assess economic data and the potential timing of Fed rate cuts. Current market expectations are that the Fed will almost certainly initiate rate cuts at the September 2024 Federal Open Market Committee meeting.6
The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on short-term bonds exceeding those of some longer-term bonds. This environment has been in place since 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 July 23, 2024, 3-month Treasury bills yielded 5.41% and 2-year Treasury yields were 4.40%, compared to the 4.25% yield on the 10-year Treasury.1
“Short-term yields represented in the Treasury curve, such as the 3-month Treasury bill yields, are firmly anchored to the fed funds target rate,” says Haworth. “It’s not likely that short-term rates will meaningfully decline until the Fed begins cutting rates.”
Bond yields remain significantly higher than was the case at the start of 2022, attributed to three key factors, according to Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “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.
“Bond investors are most susceptible to the impacts of elevated inflation,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “Fixed income still plays a role, but in the current environment, investors may wish to consider scaling back bond positions given the potential for inflation remaining sticky.”
As of June 1, the Fed began scaling back its bond reduction program. According to a Fed statement, it will “slow the pace of decline in its securities holdings” by reducing its redemption of U.S. Treasury securities from $60 billion per month to $25 billion per month.7 “This change signals that the Fed is somewhat comfortable maintaining a higher balance sheet of bond assets,” says Haworth. The Fed currently holds $7.2 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 2019.8
How should investors approach fixed income markets today? In a portfolio that mixes stocks, bonds and real assets, it may be a time to modestly underweight fixed income positions. “Bond investors are most susceptible to the impacts of elevated inflation,” says Haworth. “Fixed income still plays a role, but in the current environment, investors may wish to consider scaling back bond positions given the potential for inflation remaining sticky.” Haworth says one way for investors to address inflation concerns is with a small position in Treasury Inflation Protected Securities (TIPS). “TIPS are most practical for investors with a low risk tolerance who are looking to protect their portfolios against inflation risks,” says Haworth.
Additional opportunities exist depending on investors’ 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. Certain 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 insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors for certain eligible investors.
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.
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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