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Spring 2024 Investment Outlook – April 10
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Key takeaways
U.S. Treasury yields appear modestly rangebound so far this year.
Yields on the benchmark 10-year U.S. Treasury moved higher at the start of 2024 but are mostly holding between 4.20% and 4.30% now, well below earlier peaks of nearly 5%.
Bonds in the current environment appear to offer investors more attractive long-term opportunities.
Interest rates generally trended higher in the opening weeks of 2024, as investors assess economic data and pending monetary policy decisions from the Federal Reserve (Fed).
“Publicly released economic data is sending investors mixed signals,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “Economic growth remains solid, which might indicate interest rates need to remain elevated for some time. Yet inflation has slowed a bit, which is a sign that rates might come down.”
The yield on the benchmark 10-year U.S. Treasury note started the year at 3.88%, but moved to as high as 4.33% in February before backing off by month’s end. Over the first two months of the year, the 10-year Treasury yield generally ranged between 3.90% and 4.30%. By comparison, the 10-year Treasury yield peaked at nearly 5% in October 2023.1
The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on short-term bonds exceeding those of longer-term bonds. For example, as of the end of February 2024, 3-month Treasury bills yielded 5.45% and 2-year Treasury yields were 4.64%, while the yield on 10-year Treasury notes was even lower, at 4.25%.1 However, investors are anticipating a change in the interest rate environment in 2024.
The current rate structure emerged after the Federal Reserve (Fed) began raising the short-term interest rate it controls – the federal funds rate – in early 2022. Between March 2022 and July 2023, the Fed raised rates eleven times, from near 0% to an upper range of 5.50%. Since then, the Fed has held the line on further rate hikes and made clear that it will begin cutting rates in 2024, reversing its previous policy.
The Fed's intended policy change is likely to reverberate across the broader bond market. “If the Fed cuts short-term interest rates, yields on shorter-term debt issues are likely to decline,” says Haworth.
The major question for the market is the Fed’s interest rate-lowering timeline. “Markets got well ahead of expectations for 2024 rate cuts,” says Haworth. At the December meeting of the policy-making Federal Open Market Committee (FOMC), the indication was that three cuts would occur in 2024. “The markets, however, appeared to anticipate many more 2024 rate cuts, and long-term bond yields began to drop as a result.” says Haworth. “By early 2024, the reality set in that for now, the Fed is maintaining higher rates for longer than the markets initially anticipated.” As a result, bond markets backtracked, and rates trended higher in recent months.
How might the bond market perform this year and what does that say about how to incorporate or adjust strategies for fixed-income investors?
Changing bond market
Despite the recent decline in bond yields, they remain significantly higher than was the case at the start of 2022. “Three key factors drove the jump in bond yields,” says 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, there is an increasing supply of U.S. Treasury securities coming to the market.”
“Money sitting in cash loses purchasing power every day that inflation rates stay above zero. Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.
“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.
Haworth believes the Fed may need to reconsider its policy of reducing its balance sheet of Treasury debt given the federal government’s need to expand Treasury issuance to cover budget shortfalls and other funding priorities. “It may need to hit the brakes on its balance sheet reduction at some point in the future,” says Haworth.
Inverted yield curve persists
The yield curve, representing different bond maturities, has persistently remained inverted since late 2022. Under normal circ*mstances, 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. Many yield curve pairs using various maturities have been inverted since late 2022. This is due in large part to the Fed’s rate hikes, which have the greatest direct impact on short-term bond yields.
Haworth notes that in recent months, the inverted curve has flattened a bit. “Yields are still higher on one-month to two-year Treasuries, but the curve is following a more normal slope from the five-year level on up.” Haworth says a normal upward slope will gradually occur as the Fed begins reducing short-term rates, but the timing of that change will depend on the pace of Fed rate cuts.
Keeping an eye on the Fed
The Fed’s rate hikes were designed to slow the economy as a way to reduce inflation, which peaked at 9.1% for the 12 months ending June 2022, but dropped to 3.1% by January 2024.2
The Fed remains focused on fighting inflation but is expected at some point in 2024 to begin cutting interest rates. “When the Fed decides to do so, its focus will be less on stimulating the economy than on gradually loosening its monetary policy to return to a more neutral position,” says Haworth. “But we will need to see a number of rate cuts to reach a “neutral” fed funds rate, which the Fed indicates is 2.5%.” This compares to the current fed funds target rate range of 5.25% to 5.50%.
Finding opportunity in the bond market
How should investors approach fixed income markets today? “Money sitting in cash loses purchasing power every day that inflation rates stay above zero. Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities,” says Merz.
Despite the appeal of short-term bonds paying high yields, Merz says investors with a long-term time horizon want to build a diversified portfolio designed to generate competitive returns over time. “It’s time to take money that was shifted away from appropriate bond allocations during the period of historically low interest rates to gradually move money into longer-term bonds. Even after the recent decline in longer-term bond yields, they remain far more compelling today than they have been in years.” Merz says for conservative investors, “It’s possible to generate reasonably attractive returns in a mix of bonds without extending their risk budget.”
Additional opportunities exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit from 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.
Frequently asked questions
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 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.
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