by Lawrence Gillum, CFA, Chief Fixed Income Strategist, LPL Research
Fixed income investors may be feeling a little perplexed lately. After months of anticipation, the Federal Reserve (Fed) finally cut interest rates last week, but since then, Treasury yields are generally higher. The reason? Not only were markets expecting the rate cut, but the bond market also expects even more rate cuts over the next 12 months. Many financial markets are forward-looking, so these markets tend to price in the prospects of, in this case, rate cuts before they actually occur.
Bond markets are currently pricing in an aggressive rate cutting cycle by the Fed with the expectation that the fed funds rate will be below 3% by next July and stay at those levels for the foreseeable future. The dashed line in the chart is current market pricing for Fed rate cuts. Markets expect the Fed to cut rates eight more times before the rate cutting campaign ends at the interest rate level that many consider to be the neutral rate, which is the monetary policy rate that does not stimulate or restrict economic growth. So, for Treasury yields to fall meaningfully from current levels, economic data would need to come in weaker than the soft landing that is currently priced in.
Markets Are Pricing in an Aggressive Rate Cutting Cycle
Fed Funds Futures Market Expectations
Source: LPL Research, Bloomberg, 09/25/24
Disclosures: All indexes are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. The economic forecasts set forth in this material may not develop as predicted.
So, what’s next? History shows that without signs of recession, intermediate and longer-term yields tend to drift higher, particularly as the Treasury yield curve further disinverts. Our base case remains no recession this year and our year-end target for the 10-year Treasury yield is 3.75%–4.25%. So, while yields may move slightly higher from current levels, we still think we are past peak Treasury yields for this cycle.
And for those investors disappointed that rates haven’t fallen? For fixed income, returns generally come from two sources: income and price appreciation. Income is primarily based upon coupon payments from underlying bond holdings, whereas price appreciation comes from changing interest rates, mostly Treasury yields. And Treasury yields had fallen recently in anticipation of the Fed cutting interest rates, so it isn’t surprising that yields are now moving higher. As mentioned, the bond market still has a pretty aggressive Fed rate cutting cycle priced in, so, absent signs of further economic cooling, intermediate and longer-term rates may consolidate around current levels, or may actually move slightly higher as the Treasury yield curve goes back to upward-sloping (from inverted). That will likely limit the potential for further price appreciation in the near term.
But, if the economy, particularly the labor market, cools more than expected or if geopolitical events cause the Fed to accelerate rate cuts more than what is priced in, Treasury yields will likely fall and generate price appreciation. Historically, fixed income returns have come primarily from the income component, and with income levels still relatively attractive, we think clipping coupons is still an attractive strategy, especially versus cash.
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