Barring an idiosyncratic shock or deterioration in economic conditions and labor markets, our base case view of moderating growth and gradually cooling inflation suggests that investors who continue to hold excess cash, should begin deploying capital further out on the curve.
After the strong performance from bonds to end 2023, it appeared the worst of the bond market rout was in the rearview. Inflation had fallen consistently since the middle of 2022, Fed Chairman Jerome Powell had hinted at the possibility of reducing interest rates this year, and while growth accelerated and unemployment remained low, leading indicators signaled moderation in 2024. However, inflation proved sticky and job growth remained robust to start the year, leading to a swift and dramatic repricing for fewer rate cuts, pushing long term interest rates higher (Exhibit 1).
As markets repriced rate cuts, interest rate volatility remained elevated. While this backdrop of higher interest rate volatility and policy rate uncertainty has weighed on bond market performance this year, the adjustment higher in interest rates has dramatically improved the current income from owning U.S. Treasuries and other fixed income instruments like corporate bonds. Moreover, higher coupons should offset price losses if interest rates move modestly higher from here.
To be clear, we expect long-term interest rates as measured by the U.S. 10-year Treasury yield to stabilize between 4.00%-4.75% through the end of the year. Thereafter, we expect long rates to modestly decline to a range of 3.50%-4.00%, as the Fed gradually reduces interest rates, and growth and inflation trend to more normal levels.
A few factors will likely contribute to this corridor for long term rates in the near term:
Rate ceiling:
- Any upward pressure on rates should be limited given our expectation that year-over-year growth will moderate to 2% by the fourth quarter and real personal consumption deflator should fall to 2% by the middle of 2025.
- The wind down of the Fed’s quantitative tightening (QT) program suggest the Federal Reserve could become a net buyer of U.S. Treasuries by the end of the year, likely containing any meaningful move higher in rates1.
Rate floor:
- Long rates are likely to remain supported given the shallow path of rate reductions though 2026 and rising estimates of the perceived “neutral” policy rate or r-star2 for the US economy.
- Technical dynamics in the Treasury market, i.e. more Treasury bond supply given increased borrowing from the Federal government, should also provide a floor on rates.
Turning to short-term rates, we anticipate the Federal Reserve will reduce rates by 1-2 times by the end of the year and provide four more 25 basis point rate reductions in 2025. Thereafter, growth and inflation dynamics will largely dictate policy rates. Of course, should a recession occur, the Fed will likely respond by cutting rates aggressively, but likely not to zero like in the last cycle.
Investing during inversions
The yield curve has confounded many economists and market participants. A once reliable indicator of recession—specifically an inverted yield curve where short-term rates are higher than long-term rates—has potentially presented a false positive signal; while it has been inverted for almost two years, the economy has not fallen into recession.
That said, our rate forecasts suggest that while the curve could be positively sloped by the end of 2025 it is likely to remain inverted at least through the end of this year. Given this, investors should consider how bonds have performed under previous inversion cycles.
As shown in Exhibit 2, the initial inversion and further flattening driven by policy tightening creates a difficult backdrop for bonds, but generally maintaining a shorter duration posture is most suitable. Thereafter, as a combination of looser policy and/or slowing growth and inflation allows the curve to steepen, gradually extending duration has best served investors. That said, the shallow path for rate cuts driving by normalizing growth and inflation suggests investors may be best suited embracing a barbell approach to duration, generating still attractive yields at the front end, while owning some duration as a portfolio hedge.
Barring an idiosyncratic shock or deterioration in economic conditions and labor markets, our base case view of moderating growth and gradually cooling inflation suggests that investors who continue to hold excess cash, should begin deploying capital further out on the curve. Moreover, under this benign economic backdrop, credit spreads across investment grade and high yield could remain tight, particularly given low default rates and attractive all-in yields keeping credit markets supported. Overall, as the Fed eventually begins reducing rates, core high-quality intermediate bonds should prove to be an equity diversifier and ballast in client portfolios once again.