A sense of conviction that bonds should be bought is helping fund managers put the worst year in a generation behind them.
Even as the Federal Reserve has made clear it intends to raise rates further to insure continued progress on inflation, and that it’s not contemplating the eventual rate cuts traders are pricing in, investors are already being rewarded for seeing value in the Treasury market. With this week’s increase to 4.25%-4.5%, the central bank’s range for the federal funds rate exceeds the highest-yielding Treasury securities — a warning to investors against waiting any longer to buy.
On several occasions last week, intraday spikes in yield dissipated quickly, a sign that buyers are pouncing on them. The first occurred after the Fed decision Wednesday, spurred by policy makers’ upwardly revised median forecasts for the eventual peak in the policy rate and for inflation. Over the next two days, a deep selloff in euro-zone government bonds sparked by hawkish European Central Bank commentary caused only temporary cheapening in US rates. A steep drop in Treasury volatility this week after the Fed decision boosted investor confidence that yields won’t attain new highs.
The interest in buying bonds reflects the view that inflation probably has peaked and will fall sharply, even if the Fed isn’t ready to draw that conclusion. Also that the four percentage point increase in the policy rate since March is sowing the seeds of a recession that will lead eventually to rate cuts, if not in 2023 then in 2024.
“We believe that the outlook for 2023 is starting to brighten,” said Marion Le Morhedec, global head of fixed income at AXA Investment Managers SA. The rise in rates we’ve seen this year “adds to the attractiveness of the bond market” and central bank tightening “seems to be mostly behind us.”
Except for the two-year note’s — more sensitive than longer-maturity yields to the level of the Fed’s policy rate — rates across the Treasury spectrum are back below 4%. The two-year peaked at nearly 4.80% last month, the 10-year near 4.34% in October, both multiyear highs. The corresponding slump in bond prices erased as much as 15% of the value of the Bloomberg Treasury Index this year. While the loss has been pared to about 11%, it’s still the worst in the index’s five-decade history.
The 10-year note’s yield approached 3.40% this month, aided by signs of moderating inflation in the October and November consumer price index reports, and Fed Chair Jerome Powell previewing the slower pace of rate hikes the central bank adopted with its half-point hike on Dec. 14.
To be sure, the drop in yields from their highs raises the stakes for investors who think now’s the time to buy. The new median forecasts of Fed policy makers released after this week’s meeting showed they expect a higher peak for the fed funds rate of 5.1% next year to cope with an increased core inflation forecast to 3.5%.
Powell in the news conference following the meeting emphasized that because the labor market has yet to show any meaningful signs of softening, its unclear how long the policy rate will need to remain at its eventual peak. At the same time, policy makers’ median forecasts for 2024 include a decline in the funds rate to 4.125%.
“A 10-year at 3.5% does look a little too low, but at the same time it’s difficult to see upward pressure on government bond yields when inflation is starting to co-operate,” said Andrzej Skiba, head of the BlueBay US fixed income team at RBC Global Asset Management.