According to Haworth, “Adjustments to the target fed funds rate most directly affect the shorter end of the yield curve.” Haworth notes that the market, at least temporarily, priced in rate cuts on longer-term bonds at the end of 2023, when yields on 10-year Treasuries dropped below 4%. He also points out that (as indicated in the Feb. 20, 2024, yield curve chart above), the yield curve between five-year and 30-year bonds has begun to return to a more normal slope. “The inversion at this point is just with the very low end of the yield curve in comparison to longer-term bonds,” says Haworth. “That is likely to change based on the pace of Fed rate cuts.” After its January 2024 meeting, Fed chair Jerome Powell confirmed expectations that interest rate cuts were likely in 2024, a sign that the Fed is close to achieving its goals of taming inflation.2
Fading recession risks?
While some anticipated that a recession was on the horizon once the yield curve inverted, Haworth points out the inverted yield curve as a recession signal is somewhat questionable. “We only have data going back less than 50 years, so the causality connection may not be infallible.” The U.S. economy maintained steady growth since the Fed’s rate hikes began in early 2022, with real Gross Domestic Product (GDP) expanding at a rate of 2.5% in 2023.3 “The most recent pronouncements from the Fed indicate that they believe inflation is mostly under control given the current state of the economy,” notes Haworth. “As it turned out, we didn’t need a recession to occur to get most of the inflation out of the economy.” He points out that strong wage growth is one area of the economy still presenting inflation concerns for the Fed.
Haworth also notes that the current interest rate environment creates headwinds for business investment. “It represents a steeper cost for corporations. With short-term rates so high, companies could become increasingly reluctant to borrow, as it is more challenging to realize a payoff when investing the borrowed capital in new equipment and facilities or added employees.” Even though borrowing costs have increased, Haworth recognizes that “many corporations are not yet showing signs of distress when it comes to their debt load and continue to maintain strong balance sheets.”.
Investment considerations in today’s unusual environment
With yields higher on short-term securities, it’s no surprise investors put significant sums to work on the short-end of the yield continuum. However, Haworth recommends investors also consider longer-term bonds, with yields that are far more attractive today than they were at the start of 2022. “Investors who kept money out of long-term bonds may want to position assets back toward a more normal allocation into the longer-end of the market,” says Haworth.
One consideration for bond investors is the risk of rising interest rates. When interest rates rise, values of bonds held in an existing portfolio lose market value. “A 30-year bond is much more sensitive to interest rate movements than a 6-month bond,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management. Yet Freedman believes attractive interest rates create opportunities for investors. “It may be a time for fixed income investors to spread out exposures across the maturity spectrum.” According to Freedman, “It’s also a time to emphasize high credit quality.” Issuers with stronger credit ratings are likely to be in a better position to meet debt obligations should the economy face any challenges in the months ahead.
Check-in with your wealth planning professional to make sure you’re comfortable with your current mix of investments and that your portfolio’s asset allocations remain consistent with your goals, risk appetite and time horizon.