Key takeaways
Beginning in October 2024, a long trend of declining interest rates reversed course.
In a matter of weeks, yields on the benchmark 10-year U.S. Treasury, which dropped to near 3.6% in September, jumped more than 0.50%.
Investors may want to reexamine the role bonds play in their diversified portfolios considering current interest rate dynamics.
Following interest rate cuts by the Federal Reserve (Fed) in September, the yield on the benchmark 10-year U.S. Treasury note dropped to 3.63%, its lowest point this year. By late October, the 10-year Treasury yield approached 4.3%, an increase of 0.65%.1 While inflation worries often result in higher bond yields, that’s not the case today.
“This bond market isn’t concerned that inflation might move higher,” says Rob Haworth, senior investment strategy director for U.S. Bank Asset Management. “Instead, recent yield increases reflect expectations of stronger economic growth.”
“This bond market isn’t concerned that inflation might move higher,” says Rob Haworth, senior investment strategy director with U.S. Bank Asset Management. “Instead, recent yield increases reflect expectations of stronger economic growth.”
Even with bond yields generally trending higher in October, yields are still below previous peaks earlier this year. In April, for example, the 10-year Treasury yield stood at 4.70%.1
And while bond market total returns were negative over the first half of the year, they rose to nearly +5% in September. But as bond yields rose in October, the Bloomberg U.S. Aggregate Bond Index lost ground again, and is now up less than 2% year-to-date.2
The Fed, as it considers its monetary policy, is trying to find a sweet spot, driving inflation lower without slowing the economy to the point that it causes a recession. So far, the Fed has achieved this so-called “soft landing.” The economy continues on a positive track and inflation dropped significantly. Gross Domestic Product (GDP) growth, on an annualized basis, was 1.6% in the first quarter, 3.0% in the second quarter and 2.8% in the third quarter.3 Inflation, which peaked at more than 9% in mid-2022, now stands at 2.4%.4
The bond market continues to exhibit topsy-turvy dynamics, with yields on the shortest-term bonds exceeding those of some longer-term bonds. This inverted yield curve emerged in 2022. Under normal circumstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). As of October 28, 2024, 3-month Treasury bills yielded 4.70% and 2-year Treasury yields were 4.12%, compared to the 4.28% yield on the 10-year Treasury. In early September, 2-year yields slipped below 10-year yields and remain in that position.1
One factor that could affect Treasury bond yields going forward is the expectation of more government bonds coming to market. “New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.
“The market is demonstrating some concerns with the impact of higher government deficits,” says Haworth. “But the concern is limited so far and not having a measurable impact on bond yields.”
How should investors approach fixed income markets today? Investors may wish to consider a neutral fixed income position within portfolios that mix stocks, bonds and real assets.
Investors may want to take advantage of specific bond market opportunities, taking into account their risk tolerance and tax situation. For example, investors in high tax brackets may benefit by extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Some non-taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. And, for certain eligible investors, insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors.
Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.
The bond market is often reflective of other key factors that affect the economy. If the economy grows rapidly and inflation is rising, bond yields tend to follow suit. Bond yields also tend to rise if the Federal Reserve, the nation’s central bank, raises the short-term interest rate it controls, the federal funds target rate. Inflation in the U.S. began surging in 2021, and by early 2022, the Federal Reserve began raising rates. As a result, yields across the bond market began rising. In contrast, if the economy is slowing or maintaining modest growth with low inflation, bond yields tend to decline or remain low. This was the situation for an extended period prior to 2022. In mid-2024, bond yields began to decline again, and, in September 2024, for the first time since 2020, the Fed cut short-term rates by 0.50%. Since the Fed’s initial rate cut, long-term bond yields moved higher, likely reflecting the market’s recognition of the strong U.S. economy.
Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond’s price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates. Bondholders will generally be repaid the face value of a bond if it is held to maturity, regardless of the interest rate environment.
There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels. However, even when interest rates are low, bonds can still be appropriate for inclusion in a well-diversified portfolio.
As interest rates change, learn what the ripple effects across capital markets may mean for investors.
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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