Key takeaways
U.S. Treasury yields trended higher in 2024 until a recent pullback.
Yields on the benchmark 10-year U.S. Treasury moved as high as 4.70% in April, then retreated to 4.28% by early June before rates again moved higher.
Investors may want to reexamine the role bonds play in their diversified portfolios given today’s persistent inflation.
The bond market, particularly for longer-term bonds, gained strength in May, with yields falling and investors generally experiencing gains in their fixed income holdings. It represented a reversal of a trend that carried through 2024’s first four months. After topping out at 4.98% in October 2023, 10-year Treasury yields dropped below 4%, but trended higher from January through April 2024, with modest up-and-down-movements. The yield on the benchmark 10-year Treasury note fell from 4.79% at the end of April to 4.65% at the end of May. In June’s early trading, bond yields fell even further, declining to 4.28% by June 6, the lowest yield since the end of March. However, the environment quickly reversed course again on June 7, in the wake of a surprisingly strong labor market report. The 10-year Treasury yield jumped from 4.28% to 4.43% in a single day.1 It reflected investor concerns that labor market strength was a deterrent to potential Federal Reserve (Fed) interest rate cuts, seen as a potential boon for fixed income investments.
“We’ve seen rates decline on the long end of the market, which reflected that investors were less concerned about inflation surging again,” 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 investor focus is Federal Reserve monetary policy. While the Fed laid out a plan for three cuts to the short-term federal funds target rate it controls,2 it has also indicated that it won’t rush into rate cuts without more convincing evidence of declining inflation.3
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?
Recent signals contribute to flagging inflation fears, which may have contributed to a decline in bond yields. Job growth appeared to be slowing until May, when the economy added 272,000 jobs, a significant gain from April’s report. More labor market softness was seen in the number of job openings trending lower and the unemployment rate reaching 4%, its highest level in more than two years.4
First quarter 2024 economic growth, as measured by Gross Domestic Product (GDP), stands at an annualized rate of 1.3% in the most recent estimate. 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
However, inflation remains stubbornly high. The Consumer Price Index, a benchmark inflation measure, has remained above 3% over preceding 12-month periods since June 2023.4 Inflation’s persistence has investors convinced that the Fed won’t likely begin cutting short term rates (an economy-stimulating measure) until September 2024 or later.
“There’s little risk that long-term bond yields will rise dramatically from current levels,” says Haworth. “We’d have to see inflation rise again, a scenario that seems less likely based on current data trends.”
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 June 7, 2024, 3-month Treasury bills yielded 5.52% and 2-year Treasury yields were 4.87%, compared to the 4.43% yield on the 10-year Treasury.1
The current bond yield environment emerged after the Fed began raising the fed funds target rate in early 2022. Between March 2022 and July 2023, the Fed raised rates from near 0% to an upper range of 5.50%. The Fed’s actions were designed to temper what had been an inflation spike. Since July 2023, the Fed has held the line on further rate hikes.
“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.”
“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.”
“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.
After its April 30 – May 1 meeting, Fed Chair Jerome Powell indicated that the Fed would start scaling back its bond reduction program. According to a Fed statement, beginning in June, 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.2
The yield curve, representing different bond maturities, has persistently remained inverted 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. 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.
“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.
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.3 “This change signals that the Fed is somewhat comfortable maintaining a higher balance sheet of bond assets,” says Haworth. The Fed currently holds more than $7 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 2019.6
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 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.
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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