Mid-Year Outlook: Fixed Income

Interest rates have risen since the start of the year, contrary to consensus expectations. The major driver behind the shift up in rates was change in expectations about the path of Federal Reserve policy. Coming into the year, based on federal funds futures markets, the market expected up to six cuts in the Fed's policy rate —the federal funds rate—which would have brought it down by 150 basis points (or 1.5 percentage points).

Those hopes were dashed by rebounding economic growth and stubbornly high inflation in the first quarter. Consequently, two-year Treasury yields, which tend to closely track expectations about the path of Federal Reserve policy, rose to as high as 5% compared with 4.3% at the start of the year. Similarly, 10-year Treasury yields have risen by about 50 basis points year to date. Volatility has been elevated, reflecting the rapid change in the outlook for interest rates.

Returns to investors have been mixed. Riskier segments of the market have fared the best, largely due to higher starting yields and coupons offsetting price changes. The intermediate-term Aggregate Bond Index (AGG) which we use as a benchmark, is down fractionally year to date. Meanwhile, returns for aggressive income investments such as preferreds, bank loans and high-yield bonds have been positive.

Looking into the second half of the year, we are optimistic that returns will be stronger, but also expect volatility to remain elevated. Finding the right mix of fixed income asset classes will be the key to performance. Treasuries remain a core holding, but with the yield curve inverted, the potential for gains from price appreciation appears limited. Even with the shift in expectations, the market is still discounting rate cuts over the next few years.

We believe investors should focus on a wide range of fixed income investments for returns in the second half of the year. There is an opportunity to capture yields higher than 5% for the intermediate to long term without taking significantly more credit risk. In our view, a diversified portfolio of investment-grade corporate bonds and government agency mortgage-backed securities with durations in the six- to seven-year time frame offer attractive yields for investors looking for income and potential price appreciation.

We came into 2024 expecting the Federal Reserve to cut interest rates three to four times for a cumulative total of 75 to 100 basis points (or 0.75 to 1 percentage point). With the resilience of the economy, stubbornness of inflation, and guidance from the Fed, we have lowered that to two rate cuts and a total of 50 basis points.

The major factors weighing in favor of rate cuts are our expectations that inflation and economic growth will recede in the second half of the year. Inflation, as measured by the personal consumption expenditure deflator excluding food and energy (core PCE) has fallen steeply from its peak, but progress stalled in the first quarter. Nonetheless, the major drivers of inflation are showing signs of improvement. Rent increases are easing, job growth is slowing, and consumer spending appears to have shifted lower.

On the job front, the pace of hiring has slowed down, and wage gains have eased. The unemployment rate is still low, but it has risen to 3.9% from a low of 3.4% last year. Moreover, average hourly earnings growth has declined below 4% for the first time since June 2021.

One of the strongest signals of easing wage pressure is the "quits rate" taken from the Job Openings and Labor Turnover Survey (JOLTS). It's the rate at which workers are voluntarily leaving their jobs and is often a sign of a strong labor market. In recent months, the quits rate has fallen to the lowest level since 2018 if you exclude the early pandemic drop. It's currently consistent with wage growth in the 2% to 3% region compared to the recent trend of 4%, suggesting that the trend is likely to move lower. While the link between wage growth and inflation isn't especially strong, a declining trend suggests that the labor market is cooling off. If the trend continues, it would likely spur the Fed to cut interest rates.

Based on the likelihood of slower growth, easing inflation, and Fed rate cuts, we see room for longer-term yields to decline. However, the path to lower rates is likely to remain slow and bumpy. An important consideration is why the Fed would cut interest rates. If rate cuts are a response to declining inflation, then 10-year yields would likely drop to around 4% in the second half of the year. Since the market has already discounted rate cuts, it isn't likely to drive down long-term rates by much. However, if the Fed cuts rates in response to a weaker job market and slowing economy, then there would be room for 10-year yields to move even lower.

In addition to watching the inflation and labor market data, we are watching the trend in the term premium. Longer-term Treasury yields are the sum of expectations about the path of the fed funds rate plus a risk premium that compensates investors for committing funds for an extended time. Recently that risk premium, also known as the "term" premium, rose sharply but has since retreated.

Nonetheless, it is still well above pre-pandemic levels. After the recent bout of inflation, investors are likely to require a higher risk premium going forward, keeping yields higher than they might otherwise be and higher than pre-pandemic levels.

Concerns about the federal budget deficit could also contribute to a higher risk premium, especially heading into the presidential election where the direction of fiscal policy is unclear.

Over the long run however, there hasn't been a significant correlation between U.S. Treasury yields and the federal debt or deficit. Despite concerns, demand for Treasuries has remained strong, particularly given the wide yield advantage the U.S. has over the yields in other major developed markets.

For fixed income investors, the prospects of positive returns look good in the second half of 2024. One of the main reasons is that coupon rates—the current income paid on the bond—are at high levels. Higher coupon rates can offset price declines, because the total return an investor receives is a combination of the income stream plus or minus the price change. The higher the current income, the less significant the price fluctuation will be to the investor's total return. The chart below shows how large a change in yield would need to be for different maturities of Treasury securities to produce a negative total return over the next 12 months.

Second, the Fed is signaling it will be reducing the fed funds rate as inflation and the economy slow. The direction of Fed policy is the major driver of returns in the bond market. Over the past few months, the message from the Fed has been that it is waiting for the right time to reduce interest rates. A rate hike hasn't been ruled out, but it is not the Fed's expectation. More than once, Fed Chair Jerome Powell has indicated that the fed funds rate has likely peaked, and the next move will be a cut. Given the outsized influence that Fed policy has on bond yields, that is one explanation for why long-term rates are lower than short-term. It reflects expectations about the direction of interest rates over time.

Third, real yields are high. Real yields—the yield after inflation—are at the highest levels in many years. As inflation trends lower, the Fed will likely lower rates to prevent real yields from moving so high that they hamper economic growth.

While our expectation is that inflation will recede, many investors remain concerned about inflation. In that case it might make sense to consider Treasury Inflation Protected Securities (TIPS) as an alternative or in addition to nominal Treasuries. Yields are roughly 1.5% or more in real terms. That means that an investor who holds to maturity can expect to receive the real rate plus the rate of inflation based on the consumer price index (CPI). Consequently, if inflation does prove more persistent than current trends suggest, TIPS can offer investors a way of mitigating that risk in their bond portfolios.

In sum, we look for returns in the second half of the year to be positive even if Federal Reserve policy stays the same as it has been in the first half. We're just hoping for a lot less volatility along the way.

With short-term interest rates higher than long-term rates in the Treasury market, many investors are reluctant to extend duration. However, staying in very short-term investments presents reinvestment risk. If short-term yields fall in the future, which is likely with Fed rate cuts on the horizon, then those 5%-plus yields will not be available when it's time to reinvest the funds.

However, there are areas of the fixed income markets that can provide yields as high as short-term Treasuries at longer maturities. As the chart below illustrates, an investor looking to lock in yields above 5% for a longer time frame could choose investment-grade corporate bonds or government agency mortgage-backed securities. Those willing to take more duration and/or credit risk could consider preferred securities as well. In other words, it's possible to build a portfolio that generates yields over 5% for seven to 10 years, barring default.

Extra yield comes with more risk when compared to Treasuries, which are backed by the full faith and credit of the U.S. government. Nonetheless, we believe the risk of a default in investment-grade corporate bonds or government agency mortgage-backed securities is low in a diversified portfolio.

1. We expect interest rates to trend lower in the second half of the year. The inverted Treasury yield curve reflects that expectation. Two-year Treasury yields, which reflect market expectations for the federal funds rate one year in the future, are likely to remain below 5% and could ease back to the 4.25% to 4.40% region as expectations for Fed rate cuts shift. Ten-year Treasury yields have room to move down to the 4.0% to 4.25% region, in our view. That would still likely leave the Treasury yield curve inverted at lower levels.
2. Expect continued volatility. While we are expecting the Fed to cut the federal funds rate this year, the reason for the rate cuts is important to assessing the magnitude of easing. Inflation and employment data are the key indicators to assess the magnitude of Fed rate cuts.
3. Consider extending duration with higher-credit-quality fixed income investments. Given our expectation that interest rates are heading lower, we continue to suggest extending duration. Timing the interest rate cycle is difficult, but current yields look attractive enough to us to warrant increasing duration. A diversified portfolio of fixed income investments with higher credit quality can help investors capture attractive yields with the potential for positive total returns.