Bonds: Treasury Yields Caught Up In A Tug-Of-War
July 2024
There was a downward bias to Treasury yields in June as inflation data cooled modestly amid signs of a slowing pace of economic activity, pushing prices of U.S. Treasuries higher. The move lower in yields generated solid monthly gains for most fixed income indices, with the Bloomberg Aggregate and Bloomberg U.S. Corporate High Yield index each turning out a 0.9% return, while, surprisingly, the investment-grade Bloomberg Corporate index eked out a more modest 0.6% gain. Political uncertainty and the prospect of tariffs being placed on a broad swath of imported goods under a Trump presidency served as an offset and pushed global bond yields higher into month-end and this tug-of-war netted out to Treasury yields, broadly speaking, ending the month and quarter little changed from levels seen in early April. We expect this push/pull on rates to persist for a bit longer as doubts surrounding disinflation and political uncertainty in the U.S. and abroad leads investors to require higher compensation, i.e. yields, to take on the uncertainty/risk of inflation reaccelerating or regime change. As a counterbalance to those upside risks for yields, inflationary pressures subsiding further would lead to calls for central banks to cut rates and make monetary policy less restrictive, which would put downward pressure on yields for bonds maturing inside of 5 years but could have less of an impact on long-term Treasury yields.
We expect the prevailing ‘clip your coupon’ backdrop to remain in force for a couple more months. But historically bonds have rallied, and yields have fallen as the yield curve steepens as the FOMC begins cutting rates, setting up a profitable backdrop for fixed income investors. The FOMC is likely to cut the Fed funds rate when it meets in September, and the Committee may telegraph such a move when it meets later this month if the economic data cooperates which, broadly speaking, could lead to a better bid for bonds. Economic growth slowing and/or inflationary pressure easing more rapidly than expected would likely generate a rally in long bonds and boost an investor’s total return. However, with the terminal Fed funds rate potentially closer to 4% rather than the sub-3% currently priced in, there isn’t much term premium baked in with the 10-year yield of 4.30%. As a result, investors may shift capital into the belly of the yield curve (2 to 5-year portion) and wait for higher yields on long-term bonds before moving farther out on the curve. We continue to see opportunities to boost income, total return by maintaining allocations to higher yielding corporate bonds and U.S. dollar denominated emerging market debt, assuming positions are sized appropriately.
Credit Quietly Got Cheaper In June. Should economic data improve in the coming month(s), investors could turn toward corporate bonds across the quality spectrum with Treasuries appearing increasingly expensive after rallying last month. This could be particularly beneficial for investment grade corporate bonds which cheapened by 9 basis points during June, that largest single month move wider in over a year. Widening credit spreads weren’t enough to generate a negative total return during the month, as the positive impact from falling rates offset cheaper valuations. High-yield credit spreads were modestly higher, a trend that has been in place for three months. From our perspective, a slow drift higher in below investment grade credit spreads is the best possible outcome as market participants are presented with better risk-reward opportunities without the prospect of a sharp spike in yields that causes liquidity to seize up and risk appetite to wane. Diversification across credit and rate exposure looks like the best way to combat both current market conditions and with the effects of a shift in monetary policy in the coming months.
As of July 10, 2024
