Bond Market: Shaken, Not Stirred

Bond prices were whipsawed over the past month as volatility spiked across markets. A weaker-than-expected unemployment report raised concerns about a potential recession, sending Treasury yields sharply lower and raising expectations for larger rate cuts by the Federal Reserve.

In the same week, the Bank of Japan surprised markets with a rate hike. The suddenness of the shift in outlook led to a rapid unwinding of leveraged trades, in which investors borrowed in the low-yielding Japanese yen to invest in assets with higher returns, such as U.S. stocks. The tumult died down when subsequent data showed strength in the U.S. service sector and Bank of Japan officials expressed concern about the volatility in the yen.

When the dust settled, Treasury yields were still about 20 to 40 basis points (or 0.2% to 0.4%) lower across the yield curve than they were in mid-July.

Treasury yields declined across the yield curve

Source: Bloomberg US Treasury Actives Curve, as of 7/15/2024 and 8/12/2024.

For illustrative purposes only. Past performance is no guarantee of future results.

The good news is that Treasury bonds served as a safe haven during the market turmoil, providing valuable diversification from stocks. After a long stretch when volatility was driven by rising bond yields resulting a positive correlation with stocks, it's good to see the markets moved in opposite directions.

The bad news is that the volatility may not be over because the factors that led to the tumult are still present. The divergence in monetary policy between the U.S. Federal Reserve and Bank of Japan is likely to continue. Given how profitable it has been to borrow in yen and invest in U.S. risk assets over the years, it's likely that there may be more unwinding of those positions to go before markets stabilize.

Use of the carry trade declined sharply in summer 2024

Source: Bloomberg. Bloomberg Cumulative FX Carry Trade Index for Managed G10 Countries (FXCTG10 Index).

Daily data as of 8/12/2024. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results. Currency trading is speculative, volatile and not suitable for all investors.

Notes: The G10 Carry Trade Index measures the cumulative total return of a buy-and-hold carry trade position that is long the three highest yielding G10 currencies and is fully funded with short positions in the lowest three yielding G10 currencies. It is assumed that the investment is in three-month money-market securities, with each of the six G10 currencies assigned an equal weight in the currency basket. The basket is rebalanced daily and comprises the United States Dollar, Euro, Japanese Yen, British Pound, Canadian Dollar, Australian Dollar, New Zealand Dollar, Swiss Franc, Danish Krone, Norwegian Krone and Swedish Krona.

For bond investors, the outlook remains positive, but the plunge in yields has reduced some of the opportunity for gains. Ten-year Treasury yields reached our fair value level of 3.8% recently. We see room for yields to fall somewhat further, but much of the anticipated decline has happened.

As we look out at the next few months, we expect the Fed to lower the target range for the federal funds rate by 75 basis points, or 0.75%, in incremental steps from the current range of 5.25% to 5.5%. There are several reasons for the Fed to begin rate cuts soon. The rise in the unemployment rate to 4.3% from a low of 3.4% last year suggests that prospects for job growth are deteriorating. The declining trend in wage gains point to the prospect of lower demand for workers and less income growth for consumers. In the past, a rising unemployment rate has been a signal of recession. The "Sahm Rule"—when the unemployment rate increases by 0.5% above the three-month average relative to the low—has been triggered. We expect the Fed to respond to this signal by lowering rates by 25 basis points at its September meeting and then two more times by year end.

The Sahm rule has been triggered

Source: Bloomberg and the Schwab Center for Financial Research, as of 7/31/2024.

United States Sahm Rule Recession Indicator Real Time (SAHMRLRT Index).

Note: The Sahm rule is the three-month moving average of the unemployment rate minus its prior 12-month low. Shaded areas represent recessions.

With the economy showing signs of slowing down, and inflation near the Fed's 2% target, it doesn't make sense for the Fed to keep its policy "restrictive." If the Fed's concern is that inflation might rebound, it hasn't made the case for what would cause that to happen. Commodity prices have fallen back to pre-pandemic levels or lower due to sluggish global growth. Personal income growth has slowed, which should limit the growth in demand, and companies have turned cautious on price hikes. Populations in major developed countries are aging, which typically means lower consumer demand. That's not a backdrop that would likely result in a significant increase in inflation pressures.

We see room for the fed funds rate to fall to the 3% region over the next year or two. The Treasury market has already discounted some of that decline, but there is more room for short-to-intermediate term maturity yields to fall. Yields for longer-term bonds have already fallen to levels that are consistent with a cycle of rate cuts. Consequently, we continue to anticipate that the Treasury yield curve will "bull steepen," with short-term rates falling more than long-term rates. In fact, the yield briefly un-inverted during the market turmoil—a trend we expect to continue.

The two-year/10-year yield curve briefly un-inverted

Source: Bloomberg. Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USCY2Y10 INDEX).

Daily data as of 8/12/2024.

Note: The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. Past performance is no guarantee of future results.

Continue to look beyond Treasuries

While Treasury yields have largely reached our targets for the year, we still see opportunities in other areas of the fixed income markets. We continue to focus on higher-credit-quality bonds, such as investment-grade¹ corporate bonds, where yields are currently in the 5% region as a way to capture an attractive income stream for five to seven years. For investors in high tax brackets, investment-grade municipal bonds can also provide tax-adjusted yields that are above Treasuries and corporate bonds. Investors with long time horizons and higher risk tolerance may want to consider preferred securities.

But we do look for bouts of volatility to be an ongoing feature of the markets. When long-term trends change, there are often periods when embedded strategies get shaken out. During those times, holding high-quality fixed income can be a stabilizing force, helping to provide capital preservation, income, and diversification from stocks.

¹ The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.

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