How Changing Interest Rates Affect Bonds | US. Bank (2024)

The timing of the expected Federal Reserve (Fed) rate cuts in question kept bond yields rising for most of the year – within a modest range. At the beginning of April, the yield on the ten-year US Treasury bond rose, rising 0.2% in one day.

“Economic growth remains solid, which suggests that interest rates will remain high for some time to come,” said Rob Haworth, senior director of US investment strategy. Asset management of banks. "The latest data suggests that inflation may remain higher for longer, and we are also seeing foreign buyers withdrawing from the US market. Both factors are also helping to keep bond yields higher."

The yield on the 10-year US Treasury bond started the year at 3.88%, but rose to 4.55% in early April.¹The latest jump followed a government report showing that inflation for the 12-month period ending March 2024 rose to 3.5%, the highest level since September 2023.2 after peaking at 4.98% in October 2023, ten for years. Government rates fell below 4% but have risen modestly up and down through 2024.¹

The bond market in 2024 continues to exhibit turbulent dynamics, with yields on short-term bonds higher than those on longer-term bonds. For example, 3-month treasury bills as of April 10, 2024 were 5.45%, and 2-year government bonds were 4.97%, compared to a 4.55% yield on 10-year government bonds.¹The Fed is keeping the door open for potentialFederal Funds-doelrenterate cuts later this year, but the latest inflation data could further delay the timeline for the start of Fed rate cuts.

The current environment for bond yields emerged after the Fed began raising the short-term interest rate it controls – the federal funds rate – in early 2022. Between March 2022 and July 2023, the Fed raised interest rates eleven times, from almost 0% to an upper limit of 5.50%. Since then, the Fed has held steady on further rate hikes and indicated that it will eventually begin cutting rates in 2024, reversing its previous policy.

“If the Fed cuts short-term interest rates, short-term debt yields will likely fall,” Haworth says. “The current upward movement we have seen in bond yields reflects that markets have easily exceeded expectations for Fed rate cuts in 2024,” Haworth said. At the last meetings in political decision-makingFederal Open Market Committee (FOMC)The indication was that three reductions would take place in 2024. “However, markets seemed to anticipate many more rate cuts in 2024, and as a result, long-term bond yields began to decline in late 2023.” says Haworth. “The reality now is that the Fed is maintaining higher interest rates for longer than markets originally expected.” This resulted in the recent upward movement in bond yields.

What should investors expect from the bond market for the rest of the year, and what does that say about how strategies for fixed income investors can be integrated or adapted?

Changing bond market

Despite the recent decline in bond yields, they remain significantly higher than at the start of 2022. “Three key factors have driven the jump in bond yields,” said Bill Merz, head of US capital markets research. Asset management of banks. "First, there is the Fed's policy response to inflation. Second, there is the strength of the US economy. Finally, there is an increasing supply of US government bonds coming into the market."

“The issuance of new government bonds is growing due to a combination of the federal governmentnegative editionand the higher interest costs associated with today's high interest rates,” says Merz. At the same time that issuance is increasing, the Fed, as part of its monetary tightening policy, began maturing its large portfolio of U.S. Treasury bonds and mortgage-backed securities. “This means that other investors will have to absorb the growing supply of government bonds,” says Merz.

Haworth believes the Fed may need to reconsider its policy to reduce the national debt balance, given the federal government's need to expand Treasury issuance to cover budget deficits and other financing priorities. “It may have to put the brakes on at some point in the future when it comes to balance sheet reduction,” says Haworth.

There is an inverted yield curve

Ofrentecurve, which represents different bond maturities, has been continuously inverted since late 2022. Under normal circ*mstances, longer-term bonds yield more, which is reflected in an upward-sloping yield curve (as in the line in the chart showing the 12/31/21 yield curve). It logically reflects that investors usually demand a return premium (reflected in higher returns) for the greater uncertainty associated with borrowing money over a longer period of time. Many yield curve pairs with different maturities have been inverted since late 2022. This is largely due to the Fed's rate hikes, which have the largest direct impact on short-term bond yields.

Haworth notes that the inverse curve has flattened somewhat in recent months. “Government bond yields with a maturity of one to two years are still higher, but the curve is relatively flat from the five-year level.” Haworth says a big question is how to solve the inverted yield curve scenario. “If short-term rates fall to normalize the curve, that will reflect the Fed meeting its anti-inflation goals. If the curve normalizes because long-term interest rates move higher, that likely means inflation will remain high, leading to other challenges. for the Fed and investors.”

Keep an eye on the Fed

The Fed's rate hikes were intended to slow things downeconomyas a way to reduceinflation, which peaked at 9.1% for the 12 months ending June 2022, but fell to 3.1% in January 2024. However, inflation of 3.5% in March raises concerns that the inflation battle is far from over.²

Meanwhile, markets are closely watching the timing of the Fed's first rate cut. “If the Fed decides to do so, its focus will be less on stimulating the economy than on gradually easing its monetary policy to return to a more neutral position,” Haworth said. “But we will need a series of rate cuts to reach a 'neutral' Fed Funds rate, which the Fed estimates is 2.5%.” This compares to the current Fed Funds target rate of 5.25% to 5.50%.

Finding opportunities in the bond market

How should investors approach fixed income markets today? "Money is cashEvery day that inflation remains above zero, the economy loses purchasing power,” says Merz. “Investors with a low risk tolerance can offset the impact of inflation on their purchasing power and, in the current environment, increase their purchasing power by owning bonds with different maturities.”

Despite the appeal of short-term bonds that deliver higher returns, Merz says investors with a long-term horizon are well served by building diversified portfolios designed to generate competitive returns over time. “It is time to gradually move money taken out of the right bond allocations during the period of historically low interest rates into longer bonds. Long-term bond yields today are still much more attractive than they have been in years." For conservative investors, says Merz, "it is possible to generate reasonably attractive returns in a mix of bonds without expanding their risk budget. "

Additional options exist depending on investors' risk tolerance and tax situation. For example, investors in high tax brackets may benefit from extending the maturity a little longer and including an allocation to high-yield municipal bonds as a way to supplement their portfolio of investment-grade municipal bonds. Certain non-taxable investors may benefit from diversifying into mortgage-backed securities issued by non-governmental institutions. They may also include long-term U.S. Treasury bonds to manage overall portfolio duration. And insurance-linked securities can provide a way for certain qualified investors to capture differentiated cash flows with low correlation to other portfolio factors.

Talk to your wealth professionalfor more information on how to position your fixed income investments as part of a diversified portfolio.

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