It’s (mostly) the unknowns that are spurring interest rates higher

Fixed Income Perspectives

January 13, 2025

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

Key Takeaways

  • Since mid-September, the sharp increase in yields is largely attributable to rising “term premia” or the extra compensation investors are demanding for elevated fiscal policy uncertainty.
  • From current levels, we expect the U.S.’s large yield advantage relative to global peers, moderating domestic growth, and the G.O.P.’s slim majority in Congress to dampen upward yield moves.
  • The recent rise in yields creates an opportunity to add duration exposure in portfolios still short of their benchmarks.

Rising rates defying the typical reaction to Fed cuts

Historically, the Federal Reserve (Fed) begins lowering the federal funds rate (i.e., become less restrictive) in response to moderating economic growth, easing inflation, and/or cooling labor conditions. For much of last year, these requisites were in place, supporting a somewhat easier Fed stance. However, inflation, growth, and the labor market have exhibited a surprising amount of resiliency in recent months that is challenging the Fed’s progress toward its dual mandate. As a result, the Fed now expects to lower policy rates much more gradually in 2025 than expected a few months ago.

However, long-run inflation expectations have remained relatively stable and growth continues to slowly normalize. Thus, another force is driving most of the increase in longer-dated interest rates: term premia. Term premium is best thought of as the extra yield an investor demands as compensation for rising uncertainty. Right now, fiscal policy is the source of ambiguity, namely around tariffs, immigration, tax cuts, and their ultimate impact on inflation, deficits, and U.S. debt issuance. Since mid-September, rising term premia in U.S. Treasury notes has accounted for roughly 82% of the rise in the 10-year U.S. Treasury yield from 3.6% to 4.8%. Since early December, the term premia’s contribution is closer to 100%.

We expect interest rates to find stability soon

There are several forces at work that suggest interest rates will find more stability. For one, intermediate- and long-dated U.S. yields are at their highest levels relative to our developed global peers since 2019 and far above their long-run averages. This is fueling exceptional demand from overseas buyers, something we expect to continue. At this week’s latest auctions, domestic buying also accelerated as current yields appeared to entice more buyers.

From a technical perspective, the magnitude and pace of the recent yield increases appears unsustainable. We are now at levels consistent with a near-term retreat to somewhat lower yields. The 10-year yield is also flirting with levels (4.75-5.00%) that have previously created some angst in U.S. equity markets that ultimately led to interest rates falling.

Lastly, the market has digested a great deal of speculation and rhetoric around the incoming administration’s policy agenda. Post January 20th, traders should find some comfort in more concrete details. It is worth noting that the Republican majority within both chambers of Congress is very tight. This will make transformational fiscal policy shifts difficult to achieve without a degree of bipartisan support.

Bottom line

The policy uncertainties created by the transition in Washington is disrupting the typical bond market reaction to a Fed cut cycle. Their sharp rise has restored value in duration, creating an opportunity to add exposure in the 3- to 10-year portion of the yield curve, specifically for portfolios concentrated in ultra-short fixed income. Current yield levels provide a significant cushion for forward-looking returns. For illustration, a 5-year U.S. Treasury note bought today would still generate positive total returns over the next 12 months even if yields were to rise by 125 basis points (1.25%).

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