What the Bond Market Knows for Certain… That Just Ain’t So

A favorite Mark Twain aphorism states, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” Bond markets began 2024 with certainty that a return to 2% inflation would allow the US Federal Reserve (“Fed”) to cut interest rates in March and at every Federal Open Market Committee (“FOMC”) meeting that followed. But what bond markets knew for sure turned out to not be so—leading to “trouble” (or disappointment) in the form of negative 1.50% returns to start the year.

Now, market pricing is more closely aligned with the Fed’s rate cut projections for 2024, creating a better entry point for duration. And fading recession and default fears have improved the outlook for credit. But what the Fed (and markets) know for sure—that policy is restrictive—remains uncertain and a risk to the outlook for bonds. Dynamics such as easing financial conditions from higher asset prices could continue to challenge the level of policy restrictiveness and undermine expected rate cuts.

Key points

  • What the Fed (and bond market) knows for certain: The bond market outlook has improved as expected rate cuts align more closely with the Fed. But these expectations reflect the view that policy is restrictive, which remains challenged by strong economic data. Easing financial conditions from asset price changes may lead to continued uncertainty around policy restrictiveness, undermining the urgency and need for policy normalization.
  • Where you hold your duration matters as much as how much you hold: The yield curve tends to steepen during cutting cycles as interest rates closest to the Fed’s policy rate react more to rate cuts than longer maturities. Historically, curve steepening has resulted in the highest returns for the 3-5 year part of the curve. But the longer it takes for the anticipated cutting cycle to begin, investors positioned for steepening could miss out on the stronger risk-adjusted returns in the highest yielding short duration instruments.
  • The decoupling of “quality” in equity and credit markets: Equity and fixed income measures of balance sheet quality frequently move in tandem. However, the outperformance of quality equity exposures has been out of synch with credit markets this year, as credit spreads have tightened significantly with fading recession and default risks. Given the benign economic backdrop, the desirability of quality stocks may have more to do with balancing the risks of secular growth exposures in portfolios than the expectation for credit deterioration.