For a second year in a row, U.S. Treasurys have acted like a wrecking ball, with big swings in yields often calling the tune for the stock market and other assets.
The market looks steadier heading into year’s end, with renewed buying interest sending the benchmark 10-year Treasury yield down from a 16-year high above 5% reached in October.
One broad-based measure of fixed-income returns also had its best month in almost 40 years in November. That helped the broader bond market avoid a historic third straight year of losses. But there are still plenty of questions about what 2024 will bring.
Perhaps one of the biggest uncertainties revolves around whether Treasurys, described as the world’s safe, “risk-free” asset, may become less tumultuous in 2024 after causing so much damage in the past few years.
Many traders and investors are counting on inflation to keep easing enough to put a definitive end to the Federal Reserve’s aggressive rate-hike cycle, while also making way for lower borrowing costs next year.
“We’ve gone through the pain of repricing risk-free rates, and it’s been a two-year battle for financial markets in a rising-rate scenario,” said Thomas Urano, co-chief investment officer at fixed-income asset manager Sage Advisory in Austin, Texas, which oversaw more than $23 billion as of October. “But as we get to the end of the hiking cycle, the return profile in risk-free rates looks much better now than when we started this process.”
With the 10-year yield now holding above 4%, some hold the view that a serious retreat in U.S. economic growth is what’s needed to push the 10-year back below 3.5%. Sinking U.S. bond yields during November have helped move the S&P 500 index SPX closer to reclaiming its record high set in January 2022.
The risk to the outlook on rates is “if this inflation path we are on, in which price pressures have been easing over the past six months, somehow reverses course and it reaccelerates,” Urano said via phone. “But I see a reacceleration of inflation as the smallest-probability outcome,” he said, adding that he regards investment-grade corporate credit as a “pretty attractive” choice within fixed income right now despite the possibility of a recession or an economic slowdown.
At Los Angeles-based Capital Group, which oversaw more than $2.3 trillion in assets as of June, fixed-income portfolio manager David Hoag said he’s a “firm believer” in active management, and that it makes sense for investors to move money off the sidelines and back into the markets. In particular, he said 2- to 5-year U.S. government debt looks more attractive than 10- and 30-year maturities because there’s better value in the shorter-to-intermediate end of the Treasury curve, where yields aren’t likely to go much higher from here.
Treasury yields serve as the benchmark to finance mortgages, autos and student loans. They move up or down based on a number of variables that include the market’s expectations for U.S. growth, inflation and interest rates. When they go higher, they boost the cost of borrowing for households and businesses, as well as the likelihood of defaults, and can dent the appeal of riskier assets by making returns on risk-free government debt look more attractive.
As of Wednesday, 10-year BX:TMUBMUSD10Y and 30-year rates BX:TMUBMUSD30Y finished the New York session at 4.12% and 4.22%, respectively. That’s up by more than two full percentage points since the start of 2021, which marked the beginning of the bond market’s almost three-year run of losses.
While many bond indexes remain on pace for negative three-year returns, November’s rally helped lift the Bloomberg U.S. Aggregate to a 2.82% return year to date as of Tuesday, according to FactSet.
That reflects how the steep run-up in market-implied rates of the past few years has more recently spurred the interest of potential buyers. Long-dated Treasury yields have fallen from where they were in October because of this buying interest, growing expectations for a 2024 Fed rate cut by March and consumer-price inflation that’s dropped to an annual headline rate of 3.2% from a peak of 9.1% in June 2022.
Nonetheless, the risk of additional Treasury selloffs that could rattle broader markets remains in place. That’s because of a continued onslaught of supply from Treasury, the loss of big buyers like the Federal Reserve and foreign investors, and worries about the U.S.’s fiscal trajectory, which prompted Moody’s to lower its outlook on the country’s credit rating in November.
“The last two years have been tumultuous and a lot of that has been driven by rate increases we haven’t seen in a long time. We are moving into a new paradigm in which investors can get income in higher-quality parts of the capital structure,” such as in investment-grade corporate credit, mortgage-backed securities and Treasurys, said Rob Daly, who oversees about $4.5 billion in fixed-income assets for Glenmede Investment Management in Philadelphia.
“The adjustment period from zero rates to higher rates is inevitably painful, but is moving toward one of less pain,” Daly said via phone. “You don’t have to take as much risk to get a decent return.”
Meanwhile, almost $6 trillion in cash is sitting in money-market funds, creating a debate over whether investors will wind up deploying some portion of it into risk assets or equities.
The side that favors remaining in cash sees a need for investors to prepare for a steeper-than-expected U.S. slowdown and a Fed that is disinclined to cut rates quickly after pushing borrowing costs into restrictive levels. The other side of the debate expects cash-hoarding investors to plow into equities on the view that any economic downturn is likely to be mild and inflation should keep decelerating, pushing yields lower.
Seema Shah, chief global strategist for Principal Asset Management, said this substantial pool of cash is likely poised to fuel a significant rally in risk assets, given her view that such a downturn should quickly come and go.
However, Michael Green, chief strategist and portfolio manager at New York-based Simplify Asset Management, thinks otherwise. Via phone, Green said it’s extremely hard to know how long any downturn could last, and he’s more concerned about the U.S. economic outlook given the Fed’s “rapid and extreme” pace of rate hikes.
“Unfortunately, it’s gotten a little more challenging for investors,” said Green, whose firm oversees $3 billion in assets and offers alternative strategies through roughly 20 exchange-traded funds.
“The preferred asset should be cash under these conditions, and we think that sitting on cash in money-market funds will deliver higher-than-expected returns,” he said. “My general sense is that with the economy slowing down, investors are less likely to deploy cash elsewhere and are more likely to seek out safety.”