With Fed easing potentially on hold, what does this mean for fixed-income investors?

12 June 2024

Howard C. Greene, Senior Portfolio Manager

Jeffrey N. Given, Senior Portfolio Manager

Connor Minnaar, Portfolio Manager

Pranay Sonalkar, Associate Portfolio Manager

Expectations for monetary policy have reversed sharply since the beginning of the year, with the market pricing in fewer rate cuts as inflation has proved to be surprisingly sticky. Find out why we remain confident that U.S. high-quality intermediate fixed income still presents a compelling opportunity for investors.

As we entered the new year, there was widespread belief that the U.S. Federal Reserve (Fed) had seen remarkable success in taming inflation. After surging to over 9% in June 2022, the Consumer Price Index fell significantly, settling just above 3% in the last months of 2023. Moderating inflation led the central bank to pause, keeping rates steady since July 2023 while signaling that rates may have peaked for this cycle.

Consequently, markets had become increasingly certain that the Fed would likely begin cutting rates sometime in 2024. By year’s end, markets had priced in approximately six rate cuts, leading to a decline in the 10-year U.S. Treasury yield, boosting bond markets in the fourth quarter.

The resilient U.S. economy

Since then, markets have been surprised by several data points that have come in above expectations, hinting that inflation may be stickier than anticipated. The economy has also displayed surprising resilience, with a robust labor market showing no signs of slowing down. As these data points have trickled in, expectations for the number of rate cuts this year have softened significantly. As of the end of the first quarter, the market is now pricing in less than three rate cuts through the end of 2024. 

The market is expecting fewer rate cuts in 2024

Source: Bloomberg, U.S. Treasury, as of 31 March, 2024. Past performance is not a guarantee of future results. No forecasts are guaranteed.

How does this affect the outlook for fixed-income?

With a Fed pivot potentially off the table for the foreseeable future, investors may be wondering how this changes the outlook for fixed income. In our view, this shift shouldn’t deter investors from considering an allocation to high-quality intermediate fixed income.

As we’ve emphasized for some time, we believe that the best offense is a good defense, particularly in uncertain market environments like the one we now face. With rates likely to remain higher for longer, we believe this strengthens the argument for prioritizing quality and liquidity. U.S. Treasuries and mortgage-backed securities continue to offer historically elevated yields, with current yields well above their long-term average, providing investors with high levels of income without sacrificing credit quality. 

High-quality bonds are offering yields above their 20-year average

Source: FactSet, as of 30 April, 2024. The Bloomberg U.S. Aggregate Government/Treasury Index tracks the performance of public obligations of the U.S. Treasury comprising U.S. Treasury bonds and notes across maturities ranging from one to thirty years. The Bloomberg U.S. Aggregate Securitized Mortgage-Backed Securities (MBS) Index tracks the performance of investment-grade U.S. securitized MBS. Standard deviation is a statistical measure of the historic volatility of a portfolio. It measures the fluctuation of a fund’s periodic returns from the mean or average. The larger the deviation, the larger the standard deviation and the higher the risk. Past performance does not guarantee future results. It is not possible to invest directly in an index.

From a global perspective, U.S. Treasuries look compelling through a relative value lens as well. Not only do Treasuries offer some of the highest yields among developed markets, central banks such as the European Central Bank (ECB) and Bank of England (BoE) have indicated the potential for rate cuts in the coming months. This divergence in policy could offer further support for U.S. Treasuries as investors pursue higher yields.

U.S. Treasuries are offering some of the highest yields across developed markets

Global 10-year government bond yields

Source: CNBC, as of 16 May, 2024.

We also believe that technical factors within the corporate bond market could provide support for U.S. Treasuries in the months ahead. While market supply has been able to keep up with unusually strong demand¹ for corporate bonds this year, investors might shift to Treasuries as an alternative if demand outpaces supply in the future, especially now that yields are above 4%.

Finally, it’s important to recognize that the Fed is likely to approach further rate hikes with the same caution as a policy pivot since inflation isn’t the central bank’s sole focus: The Fed is tasked with a dual mandate, seeking to balance maximum employment with stable prices.

Keeping this in mind, the advance estimate of first-quarter GDP shows that the Fed faces a challenging task, with economic growth falling short of expectations while inflation exceeded estimates. Given the precarious task that the Fed finds itself up against, we believe that this uncertain environment continues to highlight the value of active management within fixed income. 

Why invest in high-quality fixed income now?

Although the elevated level of fixed-income volatility isn’t optimal, high-quality bonds continue to offer some of the highest rates that we’ve seen in years. Historical data shows that starting yields explain 90% of five-year forward returns, suggesting that fixed income presents the potential for investors to generate positive total return, even if the rate cuts don’t materialize any time soon. In addition to offering attractive yields, high-quality fixed income can also serve as a potential source of diversification if we see an equity drawdown.

In summary, we believe that actively managed, fixed-income portfolios that prioritize quality and liquidity can maintain a yield advantage while also being well positioned to adapt if the economy does begin to lose steam. 

1 Source: “Bubbly” Corporate Bond Market Risks Getting Ahead of Itself, Bank of America Says, Bloomberg, 22 February, 2024.