Key takeaways
After trending higher earlier in the year, 10-year U.S. Treasury yields have reversed course.
Yields on the benchmark 10-year U.S. Treasury moved as high as 4.70% in April but fell back below 4% by August.
Investors may want to reexamine the role bonds play in their diversified portfolios considering current interest rate dynamics.
Yields on the benchmark 10-year Treasury note in August dropped below 4% for the first time since 2024’s opening week. Yields were significantly lower than a 2024 peak of 4.70% in April, and nearly 5% reached in October 2023.1 With yields declining, bond market total returns moved into modestly positive territory year-to-date in July, based on the Bloomberg U.S. Aggregate Bond Index.2
Bond yields shifted this year, in part reflecting investor expectations of evolving Federal Reserve (Fed) interest rate policy. After raising rates dramatically over a 16-month period ending in July 2023, the Fed has held the line on the short-term federal funds target rate it controls. As early as late 2023, investors began to price in the anticipated onset of the Fed rate cuts. 10-year Treasury yields fell below 4% before 2023’s end. However, the Fed remained concerned about elevated inflation and held the line on the fed funds target rate through its July 2024 meeting. But now markets are anticipating rate cuts from the Fed in September. And yields again declined as a result.
“Ultimately, declining yields on the long end of the bond market reflect long-term inflation and economic growth expectations,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The short end of the yield curve has mostly held steady, more directly anchored to the Fed’s stance on the fed funds rate.”
While the Fed seeks to maintain low inflation and maximum employment, in the last 2+ years, the Fed has primarily focused on its inflation mandate. Encouraging signs to investors were recent comments by Fed chair Jerome Powell.
“When we were far away from our inflation mandate, we had to focus on that. Now we’re back to a closer to even focus, so we’re looking at labor market conditions and asking whether we’re getting what we’re seeing,” said Powell.3 A primary inflation measure, the Consumer Price Index (CPI) stood at 2.9% for the 12-months ending in July, its lowest reading since March 21.
In the meantime, July’s unemployment rate ticked up to 4.3%, its highest level since October 2021.4 In early August, investors reflected concern that labor market weakness was a potential risk to future economic growth. Stock prices temporarily declined, though regained lost ground since. Bond yields declined at that point as well but have generally remained lower since.
What should investors expect from the bond market and Fed interest rate policy for the remainder of the year and what does that say about how to incorporate or adjust strategies for fixed-income investors?
The Fed is trying to find a sweet spot, driving inflation lower without slowing the economy to the point that it causes a recession. So far, the Fed has achieved this so-called “soft landing” for the economy, but the Fed continues to walk an economic tightrope. “The overriding pressures on Treasury yields are the Fed, Treasury supply and then growth and inflation,” says Tom Hainlin, senior investment strategist, U.S. Bank Wealth Management.
To this point, the economy continues on a positive track. Second quarter 2024 economic growth as measured by Gross Domestic Product (GDP), was 2.8% (annualized rate), double its first quarter level. That’s lower than 2023’s final two quarters, which registered annualized GDP gains of 4.9% (third quarter) and 3.4% (4th quarter).5
Given the back-and-forth of economic data, investors can expect that yields will fluctuate in a modest range, at least in the near term, as markets assess economic prospects. Current market expectations are that the Fed will almost certainly initiate rate cuts at the September 2024 Federal Open Market Committee (FOMC) meeting. The bigger question is whether the rate cut will be 0.50% or a more modest 0.25%. Current market expectations are leaning toward a more modest cut, though Fed officials may provide additional guidance before it sets interest rate policy at the mid-September FOMC meeting.6
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 inverted yield curve emerged in 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 August 20, 2024, 3-month Treasury bills yielded 5.31% and 2-year Treasury yields were 4.06%, compared to the 3.86% yield on the 10-year Treasury.1
“It’s not likely that short-term rates will meaningfully decline until the Fed begins cutting rates,” says Haworth. “But one rate cut might be enough to push 2-year Treasury yields below those of 10-year Treasuries.”
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.”
“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.
“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.”
As of June 1, the Fed began scaling back its bond reduction program. The Fed reduced its redemption of U.S. Treasury securities from $60 billion per month to $25 billion per month.7 “This change signals that the Fed is somewhat comfortable maintaining a higher balance sheet of bond assets,” says Haworth. The Fed currently holds just less than $7.2 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 2019.8
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.”
Bond market opportunities still exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit by 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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