Mid-Year Outlook: Fixed Income

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.

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.

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.

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.

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.

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.

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.

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.