Key takeaways
Beginning in October 2024, an extended trend of declining long-term interest rates reversed course.
In a matter of weeks, yields on the benchmark 10-year U.S. Treasury, which dropped to around 3.6% in September, jumped back up to 4.4% by November.
Investors may want to reexamine the role bonds play in their diversified portfolios considering current market dynamics.
While shorter-term bond yields have declined significantly since 2023, yields on longer-term bonds are trending higher as 2024 ends. Investors appear focused less on recent Federal Reserve (Fed) interest rate cuts, and more on continued solid economic data and inflation trends. Yields on the benchmark 10-year U.S. Treasury, which in mid-September dropped to 3.63%, within two months once again topped 4.40%.1
At its meetings in September and November, Fed policymakers dropped the fed funds target rate by a total of 0.75%, with an additional 0.25% cut anticipated in December 2025. Beyond that, the Fed’s future rate cut calendar seems less obvious given current economic realities (solid economic growth, sticky inflation) and uncertainties related to the potential impact of new Trump administration policies.
Prior to mid-September when the Fed began cutting rates, markets priced in those Fed actions. Once the Fed initiated rate cuts, the market’s focus changed, according to Rob Haworth, senior investment strategy director for U.S. Bank Asset Management. “The market’s higher yields are now pricing in better economic growth, but we’re not seeing higher inflation expectations, which is often what triggers an interest rate upturn.”
“This reflects our belief that in the current environment, there is more relative opportunity in equities,” says Rob Haworth, senior investment strategy director with U.S. Bank Asset Management. “It indicates our expectations that continued earnings growth, boosting equity prices, offers better opportunity than bond coupon payments, even at today’s higher rates.”
The economy is on a positive trajectory 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.2 Inflation, which peaked at more than 9% in mid-2022, now stands at 2.7%.3
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.”
Higher government deficits, occurring in conjunction with elevated interest rates, require the U.S. Treasury to increase debt supply to fund federal government spending. “The market at this point is not yet concerned with the risk of deficits driving Treasury yields higher,” says Haworth.
For more than two years, an unusual environment persisted. The yield curve, reflecting yields across the Treasury security maturity spectrum, is typically upward sloping (see the line in the chart below representing the yield curve as of Dec. 31, 2021). In a normal environment, the shortest-term securities offer the lowest yields, and those with the longest maturities pay the highest yields. However, in 2022, the yield curve inverted as short-term rates rose dramatically, exceeding long-term yields (see the line on the chart showing the yield curve on June 30, 2023). In recent months, the market began shifting. On December 13, for the first time since 2022, the 3-month Treasury bill yield dropped below that of the 10-year U.S. Treasury note (see the line representing the yield curve on Dec. 13, 2024).1 “It seems reasonable to expect the yield curve will remain relatively flat in the near term,” says Haworth. “To see a normal upward sloping yield curve might require continued strong economic growth, which would likely keep long-term yields higher.” Haworth says such a trend would need to be combined with modest enough inflation to allow the Fed to continue cutting short-term rates, which would be reflected on the shorter end of the yield curve.
How should investors approach fixed income markets today? Investors may wish to modestly underweight their fixed income position within portfolios that mix stocks, bonds and real assets. “This reflects our belief that in the current environment, there is more relative opportunities in equities,” says Haworth. “It indicates our expectations that continued earnings growth, boosting equity prices, offers better opportunity than bond coupon payments, even at today’s higher rates.”
Nevertheless, Haworth says that within their bond portfolios, investors may want to take advantage of specific market opportunities in accordance with 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 also rose. 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, the Fed began what was expected to be a series of rate cuts. 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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