Fed pivot and massive yield decline is pulling forward strong returns

Fixed Income Perspectives

December 14, 2023

Fixed Income Perspective offers our views on top-of-mind fixed income themes.

Key Takeaways

  • The Federal Reserve’s (Fed) dovish shift and softer inflation has fueled a powerful decline in yields from cycle highs.
  • We maintain that yields will broadly fall in 2024; however, the recent rally endorses patience in extending portfolio duration in the near term.

Fed and inflation dynamics are transforming U.S. yields

Since October 19th, the 10-year U.S. Treasury yield has declined 111 basis points (1.11%) from 4.99% to 3.88% today, its lowest level since July. The past 8 weeks have hosted the 10-year yield’s sharpest decline since 2011. When bond yields fall, bond prices rise. Over that span, the Bloomberg U.S. Aggregate Bond Index – the most prominent U.S. investment grade bond index – has rallied roughly 8%, a welcome reprieve from core fixed income’s steep losses in 2022.

U.S. Treasury yields, which serve as a reference for virtually all fixed income asset classes, are responding to two key developments: 1) Fed officials signaling the end of rate hikes and the timing of future rate cuts; and 2) a steady deceleration in inflation. We expected yields to fall as the Fed completed its tightening cycle; however, the magnitude of the recent move has likely pulled forward some of the decline we expected in 2024.

Tactical duration opportunity diminished, not eliminated

As yields rose between August and October, our view on high-quality duration (i.e., longer-dated bond exposure) grew increasingly favorable. It afforded investors the opportunity to secure the highest yields in almost two decades and capture strong total returns as yields respond to cooler inflation, slower growth, and the Fed pivot we are witnessing. Given the powerful rally in core fixed income since mid-October, our view towards adding duration is now more balanced.

For new portfolios and cash balances, we recommend starting with a neutral duration posture, especially for tactical fixed income portfolios that can react to periods of rising rates that create more compelling entry points.

Some upside yield risks remain in place

Although our work still suggests the likelihood of lower yields over the coming year, there are some offsets that remain. Ballooning federal budget deficits will continue to require robust Treasury debt issuance that may test demand. Relatedly, threats of further U.S. credit rating downgrades will loom absent improved cooperation and spending discipline within Congress. Should debt and spending concerns fuel upward rate moves again, we would view those periods as opportunities to extend portfolio duration, especially for those still short of their benchmark

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