After the Fed Pivot: Where Are the Opportunities?

The Federal Reserve’s (Fed) pivot late last year sparked an enormous rally in the bond market. In fact, U.S. Treasurys and nearly all fixed income sectors enjoyed some of their best quarterly returns on record. The sharp decline in yields over the final quarter of 2023 was a textbook reaction as market participants are well versed in what typically comes after the Fed pivots – softer growth, lower inflation and the commencement of an easing cycle. While the timing of the Fed’s easing cycle after the final rate hike varies, historically the Fed’s first rate cut has come an average of seven months after the last rate hike, based on the last six cycles.

With the Fed delivering its final rate hike in July 2023, we are now approaching the window – which has ranged from one to 14 months – where policymakers have typically kicked off their easing cycle. While notable, this cycle has been anything but average. Case in point: after 550 basis points of tightening (one of the most aggressive cycles in history), the economy continues to show surprising resilience – strong job growth, slowing, but still above-trend growth and record low unemployment. Why? The government’s ongoing fiscal expansion, where the budget deficit is now running at ~6% of GDP. While the fiscal stimulus may have lengthened the economy’s runway, our economist expects growth and inflation to slow over a six-to-12-month horizon. This expected cyclical slowdown should keep the bond market focused on the timing and pace of the Fed’s eventual rate cuts.

Starting yields are the strongest predictor of future returns

Given the ongoing strength in the labor market and still solid economic growth, the Fed can afford to exercise patience. In fact, the resilient economy has been a major factor behind why excessive rate cuts this year have been largely unwound and a key reason why Treasury yields have moved modestly higher since the start of the year. With the market now pricing in three rate cuts by year end, Treasury yields will be swayed (up or down) by the incoming data. But with the Fed telling us that interest rates have peaked for the cycle and that rate cuts are on the horizon as long as the disinflationary trend remains intact, Treasury yields will eventually be headed lower – albeit likely at a slower pace than we originally anticipated.

While our call for moderately lower yields in 2024 may be delayed as long as economic growth remains solid, we still believe the current high level of yields remains an attractive opportunity for investors. That's because the starting level of yields is the single best predictor of a bond’s total return over longer periods of time.

Where we see opportunities

Treasury yields are likely to trade in a wide range again this year given the economy is at an inflection point. In the near term, we see scope for Treasury yields to move in either direction. For example, any weaker than expected economic news (whether on the growth, jobs or inflation front) could drive yields significantly lower as the market reprices to a more aggressive Fed easing cycle—with a move to 3.5% not out of the question. Conversely, any signs of waning demand at the upcoming Treasury auctions (2024 will be another year of heavy Treasury issuance to fund the deficit) could easily push yields higher to 4.5% again. These trading ranges should create some opportunities for investors along the way. But by year end, we believe yields should be within the ballpark of where they started the year. However, with the economy still on solid footing, we are modestly raising our 10-year Treasury yield forecast to 3.75%.