Following the post-COVID stimulus hangover in 2022, the bull market has continued to run. One of the key factors was the Federal Reserve’s decision to
Rates, Rallies and Rational Expectations
Published Date : January 31, 2024
Not to be overshadowed by the strong returns from equity markets last year, bond market investors also have something to celebrate as we turn the page on 2023. After 525 basis points of rate hikes in the past two years, something shifted in 2023, and it shifted fast. The yield on the 10-year Treasury peaked near 5% in October and then staged an impressive rally to end the year close to where it started the year—around 3.9%. In the final quarter of 2023, bond fund performance soared after the Fed’s dovish pivot in December signaled an end to the rate hiking cycle and a nod to interest rate cuts in the year ahead.
Despite elevated bond market volatility throughout the year, markets rewarded investors who stayed on course. The U.S. Aggregate Bond Index finished the year up 5.5%, outperforming 3-month Treasuries by around half a percentage point for the year. It’s a feat that didn’t seem likely heading into October as yields continued to march higher. However, the combination of relatively softer jobs data, lower inflation, and a dovish Fed ignited a rally in bonds that investors had been waiting for. It offered something for everyone as tax-exempt municipal bonds finished the year up 6.4% on average, U.S. credit delivered around 8.5%, and—for those willing to take on additional risk—high-yield and emerging market bonds delivered double-digit returns.
As we think about rational expectations for 2024, we expect a modest reversal in monetary policy to pave the way for lower bond yields and positive outcomes this year, too. Using the December FOMC meeting as a guide, the Fed’s path to a “soft landing” appears to include 0.75% of rate cuts this year as inflation makes its way closer to their 2% target and growth slows without causing a significant rise in unemployment. As of early January, the market was pricing in a more aggressive path to lower interest rates and, in our view, had likely pushed the ‘rate cut narrative’ a little too far given the current benign economic backdrop. Rate cuts are unlikely to come in the first quarter of this year, barring a serious slowdown in economic activity. Instead, we anticipate the Fed Funds Rate will move closer to 4.5% later this year and will continue to remain above pre-pandemic levels.
While current bond yields are off their October peak—a seemingly fleeting moment in time—yields are still significantly higher than where they have been over the past decade. If yields remain stable this year, investors should expect to generate a return in-line with current yields. If we do get interest rate cuts or lower yields, in addition to the income, bond investors will likely experience a positive price return on their bonds, boosting the overall total return. If we’re wrong and interest rates rise, the related price declines should be moderate given the cushion provided by higher starting yields today.
In summary, in our view, the risk-reward profile of the bond market is in a healthy place today. Across the asset class, there is meaningful yield to capture at relatively attractive valuations. While the opportunity set is wide, not all bonds are created equal and it’s important to have a plan given the shift in monetary policy. Investors should consider moving away from cash, locking in relatively higher yields, and maintaining a diversified portfolio of high-quality bonds. And that is our plan of action for the assets that we manage on your behalf.
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