Fixed Income Outlook: The Rocky Road Bond Market

The case for lower interest rates in 2024 is straightforward, but the path is likely to be rocky. We expect bond yields to decline in line with falling inflation and slower economic growth, but uncertainty about the Federal Reserve's policy moves will likely be a source of volatility. Nonetheless, we are optimistic that fixed income will deliver positive returns in 2024.

The action in the bond market has been anything but plain-vanilla over the past year. Ten-year Treasury yields have spanned a huge range—from as low as 3.25% in April in the wake of the banking crisis to as high as 5.02% in October on surprisingly strong third-quarter economic growth. In 2024, we look for lower yields but expect bouts of volatility along the way, as markets continue to try to anticipate shifts in Fed policy. Assuming the Fed continues to lag market expectations for rate cuts, the market will be very attuned to every data point, likely causing yields to trade in wide ranges.

Nonetheless, we believe that both short- and long-term yields likely have peaked for the cycle and will continue to fall assuming inflation abates in 2024. In our view, much of the inflation driven by supply shortages early in this cycle has been corrected, but the full impact of the tightening in monetary policy by major central banks is still working its way through the global economy. Slower growth and less inflation pressure should be the result.

While intermediate- to long-term yields already have fallen significantly from the peak seen last October, we see more room for decline. The big questions revolve around the magnitude of the decline and the shape of the yield curve. Those trends will be driven by central bank policies.

However, we don't look for yields to fall back to the levels that prevailed in the aftermath of the 2007-2008 financial crisis or during the COVID-19 pandemic. In our view, the era of zero policy rates and quantitative easing has ended. A return to "normal" in the bond market would mean positive real yields during periods of economic expansion coupled with bouts of volatility as central banks allow markets to set rates.

The Fed's policies to quell inflation involve raising interest rates and signaling it will keep them high until inflation falls back toward its 2% target, and quantitative tightening—or reducing the size of its balance sheet. So far, the process appears to be working, with inflation having fallen by half from its peak levels.

Pushing up interest rates rapidly and holding them steady as inflation falls has resulted in a sharp increase in "real" rates—that is, yields adjusted for inflation expectations. At current levels, real yields should be high enough to put a brake on the economy. High real interest rates make it more attractive for consumers to save than spend, and more difficult for businesses to borrow, hire, and invest. While consumer spending has been resilient during the past year, rising interest rates have slowed demand for durable goods, resulting in a downturn in the manufacturing sector. Recent data suggest that the pace of growth in the service sector is moderating as well.

In addition to high real rates making borrowing more expensive, banks have tightened lending standards significantly in this cycle, limiting access to credit for both businesses and consumers.

Moreover, the Fed intends to continue its quantitative tightening program—allowing bonds on its balance sheet to mature without reinvestment—even after it shifts to lowering interest rates. So far, that process has reduced the Fed's total holdings by more than $1 trillion.

The federal funds rate, which guides overnight lending between U.S. banks, is currently 5.25% to 5.5%. However, the Fed policies combined—the "higher for longer" policy signal, quantitative tightening, and the cumulative rate hikes to date—are estimated to be the equivalent of pushing the federal funds rate to 6.7%, according to the "proxy funds rate" calculated by the San Francisco Federal Reserve Bank.

Lastly, this has been and continues to be a global tightening cycle, with central banks raising interest rates in most major and emerging market countries. The synchronized rate hikes are compounding the slowdown in domestic economic growth and inflation. As a result, the Organization for Economic Cooperation and Development (OECD) estimates that global gross domestic product growth will slow to 2.7% in 2024, slightly lower than in 2023 and significantly below the five-year pre-pandemic average of 4.6%.

While the case for lowering interest rates seems clear to us, that's not necessarily true for everyone at the Federal Reserve. Having failed to recognize the need to tighten policy early in the cycle as inflation soared, the Fed continues to signal a willingness to keep policy tight for an extended period to make sure inflation falls toward its 2% target level.

This is a significant change in strategy. In past cycles, the Fed might already have started lowering rates in response to falling inflation, but this time around it doesn't want to squander the gains it has made to date. It is waiting for data to validate a shift in policy.

The message has been that short-term rates will be higher for longer, but without much detail. From recent comments by Fed officials, it appears that the majority is growing more confident that further rate hikes aren't needed. Most concur that the current 5.25% to 5.5% target range for the federal funds rate is sufficiently high to achieve their goals, although a few are holding out the potential for one more hike. We agree with the majority that the peak in rates has been reached.

However, we don't have much clarity about how much longer rates are going to remain high. The market has gotten ahead of the Fed in anticipating rate cuts a few times over the past year only to have to unwind those expectations, causing yields to rebound sharply.

Given the uncertainty about the timing and magnitude of potential Fed rate cuts, we've constructed three hypothetical scenarios for 2024 and assessed the likely impact on Treasury yields and the yield curve.

Our base-case scenario is for three rate cuts of 25 basis points each, starting mid-year, bringing the upper bound of the target range for fed funds to 4.75%. This scenario reflects the Fed's reluctance to cut rates pre-emptively in this cycle and is generally in line with current market pricing. It would likely mean that the economy's growth rate slows down, but a recession is avoided. We would expect the yield curve to remain inverted as 10-year Treasury yields fall to 4% or lower while the federal funds rate stays elevated. However, two-year yields would likely decline below 10-year yields.

This scenario—which we believe has a low probability of occurring—calls for one more 25-basis-point rate hike by the Fed and an extended period of high rates in response to rebounding inflation. We estimate that the yield curve would likely stay inverted due to the tightening in monetary policy, but yields would stay elevated for all maturities.

This scenario assumes the Fed cuts rates by up to 150 basis points in the next 12 months due to the onset of recession. Rapid Fed rate cuts would likely mean that the yield curve would steepen due to short-term rates falling faster than long-term rates.

For fixed income investors, the good news is that the range of hypothetical potential outcomes for some commonly used strategies suggests positive returns. The chart shows the hypothetical returns for bond ladders and barbells with different maturities. We looked at one- to five-year and one- to 10-year ladders and barbells using Treasuries.

With starting yields in the 4% to 5% region, positive returns are likely, because the income generated from the coupon should offset price declines in most scenarios. If yields do rebound in 2024 relative to expectations, it would take a substantial increase to generate a negative total return, with the biggest impact on the longest duration bonds.

No matter what the scenario in the fixed income markets in 2024, it's likely to come with volatility. This cycle has been different in many ways from previous cycles and the road from high inflation to low and stable inflation likely won't be smooth. Every economic data report and Federal Reserve meeting or comment could cause an outsized reaction in the markets. However, in the long run, the trend in inflation is the biggest factor driving interest rates, and that is currently headed in the right direction. With the peak in rates likely behind us and high starting nominal and real yields, we look for lower yields and positive returns for investors.