Mid-Year Outlook: Fixed Income

Looking into the second half of the year, we are optimistic that returns will be stronger, but also expect volatility to remain elevated.

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.

Both two-year and 10-year Treasury yields have risen

Chart shows 2-year and 10-year Treasury yields dating back to June 2021. As of June 7, 2024, the 2-year yield was 4.84% and the 10-year yield was 4.40%.

Source: Bloomberg. Daily data as of 6/7/2024.

U.S. Generic 2-year Treasury Yield (USGG2YR INDEX) and U.S. Generic 10-year Treasury Yield (USGG10YR INDEX). Past performance is no guarantee of future results.

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.

Fixed income investment performance has been mixed so far this year

Chart shows year-to-date 2024 total returns for a series of fixed income investments, including bank loans, munis and Treasury bonds.

Source: Bloomberg. Total returns from 12/31/2023 through 6/3/2024.

Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Indexes representing the investment types are: Preferreds = ICE BofA Fixed Rate Preferred Securities Index; HY corporates = Bloomberg US High Yield Very Liquid (VLI) Index; Bank loans = Morningstar LSTA US Leveraged Loan 100 Index; Long-term US Agg = Bloomberg U.S. Aggregate 10+ Years Bond Index; IG floaters = Bloomberg US Floating Rate Note Index; IG corporates = Bloomberg U.S. Corporate Bond Index; US Aggregate = Bloomberg U.S. Aggregate Index; Intermediate-term US Agg = Bloomberg U.S. Aggregate 5-7 Years Bond Index; Municipals = Bloomberg US Municipal Bond Index; Treasuries = Bloomberg U.S. Treasury Index; EM (USD) = Bloomberg Emerging Markets USD Aggregate Bond Index; Securitized = Bloomberg US Securitized Index; Agencies = Bloomberg U.S. Agency Bond Total Return Index; TIPS = Bloomberg US Treasury Inflation-Protected Securities (TIPS) Index; Short-term US Agg = Bloomberg U.S. Aggregate 1-3Years Bond Index; Int. developed (x-USD) = Bloomberg Global Aggregate ex-USD Bond Index. Past performance is no guarantee of future results.

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.

Federal Reserve policy: We still expect rate cuts this year

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.

Inflation has fallen sharply from its peak

Chart shows year-over-year change in the personal consumption expenditure index and the core personal consumption expenditure index going back to April 2014. As of April 30, 2024, PCE growth was 2.7% and core PCE growth was 2.8%.

Source: Bloomberg. Monthly data as of 4/30/2024.

PCE: Personal Consumption Expenditures Price Index (PCE DEFY Index), Core PCE: Personal Consumption Expenditures: All Items Less Food & Energy (PCE CYOY Index), percent change, year over year.

Rent increases have slowed

Chart shows the changes in the Bureau of Labor Statistics' New Tenant Rent Index and the Consumer Price Index Owners Equivalent Rent index, which is shown with a 1-year lag. Both have declined from their peaks.

Source: Bloomberg. Quarterly data as of 5/31/2024.

U.S. BLS & Cleveland Fed New Tenant Index Repeat Rent NTRR YoY (CLEVNTRR Index) and U.S. CPI Urban Consumers Owners Equivalent Rent of Residences YoY NSA (CPRHOERY Index).

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.

Average hourly earnings growth has declined

Chart shows the year-over-year change in average hourly earnings dating back to May 2018. As of May 31, 2024, the year-over-year change was 4.1%, down from a peak of more than 8% that was reached in 2020.

Source: Bloomberg. Data as of 5/31/2024.

US Average Hourly Earnings All Employees Total Private Yearly Percent Change SA (AHE YOY% Index).

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.

Average hourly earnings and the quits rate

Chart shows the annualized six-month change in average hourly earnings dating back to 2010, versus the change in the JOLTS quit rate.

Source: Bloomberg. Monthly data as of 4/30/2024.

U.S. Average Hourly Earnings (AHE TOTL Index), JOLTS U.S. Quits Rate (JOLTQUIS Index), from the Job Openings and Labor Turnover Survey (JOLTS) report. Note: Y axis is capped at 8% on the upside and 0% on the downside as there were large outliers in 2020s when the 6-month annualized change in AHE rose as high 12% and fell as much as 3%.

Longer-term yields: Room to decline, but volatility likely to continue

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.

Term premia have been a factor in driving yields

Chart shows the 10-year Treasury term premium versus the U.S. term premium on a 10-year zero-coupon bond.

Source: Bloomberg. Daily data as of 6/7/2024.

Adrian Crump & Moench 10-year Treasury Term Premium (ACMTP10 Index), U.S. Term Premium on 10-year Zero Coupon Bond (KIMWTP10 Index).

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.

The U.S. has a yield advantage versus other developed market countries

Chart shows the yield to worst of the Bloomberg U.S. Aggregate Bond Index and the Bloomberg Global Aggregate ex-USD Index dating back to June 2014. As of June 3, 2024, the U.S. index yielded 5.1% and the global index yielded 3%.

Source: Bloomberg. Daily data as of 6/3/2024.

Bloomberg U.S. Aggregate Bond Total Return Index (LBUSTRUU Index) and Bloomberg Global Aggregate (LG38TRUU Index). Yield to worst is the lowest possible yield that can be received on a bond with an early-call provision. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.

Opportunities in fixed income: Look beyond Treasuries

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.

Yield change needed to produce zero total return

Chart shows the yield that would be needed to achieve a zero one-year total return for two-year, five-year, 10-year and 30-year U.S. Treasuries.

Source: Bloomberg. Data as of 6/7/2024. For illustrative purposes only.

US Treasury Actives Curve (YCGT0025 Index).

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.

Long-term yields are lower than short-term yields

Chart shows the spread between three-month and 10-year Treasury yields, calculated by selling the three-month and buying the 10-year. As of June 7, 2024, the spread was negative 99.2 basis points. A gray bar is overlaid on the chart to represent the recession from February to April 2020.

Source: Market matrix U.S. sell 3-month and buy U.S. 10-year bond yield spread (USYC3M10 Index). Daily data as of 6/7/2024.

Note: This spread is a calculated Bloomberg yield spread replicating selling the current 3-month U.S. Treasury Note and buying the current 10-year U.S. Treasury Note, then factoring the differences by 100. Gray bar represents the February-April 2020 recession.

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.

Real yields are at the highest levels in years

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.

Chart shows the changes in the real two-year and 10-year Treasury yields dating back to 2010. As of June 7, 2024, the two-year yield was 2.7% and the 10-year yield was 2.1%.

Source: Bloomberg. Daily data as of 6/7/2024.

US Generic Govt TII 2 Yr (USGGT02Y INDEX), US Generic Govt TII 10 Yr (USGGT10Y Index). Past performance is no guarantee of future results.

Look beyond Treasuries when extending duration

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.

Various fixed income investments have yields near or above 5%

Chart shows the average yield to worst for Treasury bills, intermediate-term Treasuries, the U.S. Aggregate index, agency MBS, investment-grade corporates and preferred securities. All were higher than 5% with the exception of intermediate Treasuries, which yielded 4.6%.

Source: Bloomberg, as of 6/3/2024.

Indexes represented: Treasury bills = Bloomberg US Treasury Bills TR Index, Intermediate-term Treasuries = Bloomberg US Intermediate Treasury TR Index, U.S. Aggregate Index = Bloomberg US Aggregate TR Index, Agency MBS = Bloomberg US MBS Index, IG Corporates = Bloomberg US Corporate Bond Index, Preferred Securities = ICE BofA Fixed Rate Preferred Securities Index. Yields shown are the average yield-to-worst. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

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.

Key takeaways:

  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.