Meet the New Bond, Same as the Old Bond?

The rally in bonds to close out 2023 reflects the US Federal Reserve's (“Fed’s”) validation of beginning a rate cutting cycle in 2024. Bond markets expect more cuts than the Fed is signaling, and this expectation largely reflects a return to pre-COVID dynamics of low inflation, massive central bank support, and suppressed term premia. That may turn out to be the case, but changes in economic and financial structures emerging in the post-COVID environment could disrupt the return of “old” bond market dynamics—and potentially require a different investor playbook than for past rate cutting cycles.

Key points

  • Three kinds of cuts: Cuts, damned cuts, and recessions —a twist on Mark Twain’s “three kinds of lies” quote on statistics illustrates the bond market outlook for 2024. Market consensus expects the Fed to cut interest rates either to (1) maintain restrictiveness as inflation falls, (2) calibrate monetary policy to a less restrictive stance in the face of falling inflation and a slowing economy, or (3) move to easier monetary policy in the face of a recession.
  • Structural changes underpinning a “new” bond market regime: Each of these three scenarios leads to an outlook for lower rates and positive returns for bonds. But as another Twain aphorism goes, history may rhyme, but it doesn't repeat. Post-COVID global economic and financial structural changes suggest the potential for a very different bond market playbook during a cycle of global central bank rate cuts.
  • A “new” conundrum for bonds? Within the consensus outlook for declining rates is also a consensus for rate declines to be led by the short end of the curve. We look at the potential for a “new” conundrum—playing out in the opposite way of the “old” Greenspan conundrum from the 2004/2005 hiking cycle. Back then, rate hikes at the short end were not met by rising rates at the long end, prompting the now famous “conundrum” (non) explanation. The impact of structural changes to the global market might similarly argue for longer term rates not falling as much (or even potentially rising) during this cutting cycle.

Meet the new bond, same as the old bond?

Despite heady expectations for bond returns in 2023, the near consensus “bonds are back” narrative failed to deliver the kind of returns that would validate bonds being “back.”

Now, following the stellar bond returns of November, “bonds are back” is back again as investors look forward to the typical backside of the Fed’s interest rate cycle. That cycle “typically” entails several hundred basis points of Fed rate cuts which are now reflected in bond market pricing of the short end of the yield curve (Figure 1).

Bond markets have priced in six rate cuts for 2024, with the first cut expected in March