We expect bond yields to trend gradually lower—but it may be a bumpy ride. These seven strategies may help investors take advantage.
On September 18, the US Federal Reserve launched its easing cycle with a 50-basis-point rate cut, its largest reduction in 16 years. This action aligns most major central banks in an easing phase, but it doesn’t guarantee a smooth decline in yields. Case in point: following the Fed’s cut, the yield on the 10-year Treasury actually rose. While we expect a gradual decline in global yields over the coming months, we also anticipate continued bumps along the way.
Central Bank Word of the Day: “Gradual”
The Fed—while keeping a keen eye on the strong but weakening labor market—has indicated it plans to respond to the evolution of data over time. In other words, it plans to move gradually while recalibrating to a neutral policy stance, likely reaching that point in early 2026, in our view.
The European Central Bank (ECB) cut rates 25 basis points (bps) in September—its second cut of the cycle. The ECB remains uncommitted to a particular path, preferring to take a slow, data-driven approach. The Bank of England (BOE) also prefers a gradual approach to rate cutting to help squeeze persistent inflationary pressures out of the system. The BOE began its easing cycle in August with a 25-bp move, then held steady in September. We expect the ECB and BOE each to deliver one more quarterly cut this year. While cuts could accelerate in 2025, we don’t think aggressive easing is likely.
The Bank of China has also been cutting rates to boost growth, which is trailing its 5% target for the year. While rate cuts are unlikely to aid the country’s beleaguered property sector, we believe they may boost growth prospects in other sectors that are already performing well.
The outlier among major central banks is the Bank of Japan, which has held key rates steady since tightening earlier this year for the first time since 2008. For now, it is relying primarily on passive quantitative tightening as it moves toward normalization.
Continued Volatility on the Horizon
Market participants’ efforts to divine the timing and magnitude of central bank rate cuts have brought volatility back into the market, as has geopolitical uncertainty arising from regional conflicts and elections in Europe, India, Mexico, Brazil and more. In fact, roughly half the world’s population is eligible to vote in 2024’s “year of elections.” And while US elections rarely affect market results, the upcoming US election could contribute to elevated volatility over the next few months.
In our view, investors should get comfortable with evolving policy expectations and data surprises and avoid getting swept up in short-term turbulence. Broader trends, such as moderate global economic growth and high yields, matter more. These are favorable conditions for bond investors—especially for those who can beat the eventual rush back into bonds.
Bonds May Get a Boost from Reinvestment
In our view, bonds are likely to enjoy a price boost as yields decline across most of the developed world in the coming months. That boost could be especially big given how much money remains on the sidelines, looking for an entry point. As of August 31, a record $6.6 trillion was sitting in US money-market funds, a relic of the “T-bill and chill” strategy made popular when central banks were aggressively hiking interest rates.
Historically, as central banks ease, cash floods out of money markets and back into longer-term debt. The resulting surge in demand for bonds from such flows helps reinforce the decline in yields that accompanies central bank rate cuts. Because the amount of cash sitting on the sidelines today is unprecedented, the potential surge in demand for bonds is exceptionally high. We anticipate roughly $2.5 to $3 trillion will return to the bond market over the next couple of years.
Seven Strategies for Today’s Environment
In our view, bond investors can thrive in today’s favorable environment by applying these strategies:
Get invested. If you’re still parked in cash, you’re losing out on the daily income accrual provided by higher-yielding bonds, as well as potential price gains as yields decline. In fact, in today’s environment, we believe investors should probably allocate more to fixed income than they have historically.
Extend duration. If your portfolio’s duration, or sensitivity to interest rates, has veered shorter, consider lengthening it. As interest rates decline, duration benefits portfolios. Government bonds, the purest source of duration, also provide ample liquidity and help to offset equity market volatility.
Think global. Not only do idiosyncratic opportunities increase globally as central bank timing (and direction) diverges, but the advantage provided by diversification across different interest-rate and business cycles is also more powerful.
Hold credit. We don’t think this is the time to avoid or underweight credit. Though spreads are on the tighter side, yields across credit-sensitive assets remain near historic highs. Corporate fundamentals are still in relatively good shape, having started from a position of historic strength. And falling rates should help relieve refinancing pressure on corporate issuers. That said, investors should be selective and pay attention to liquidity. Cyclical industries, CCC-rated corporates and lower-rated securitized debt are most vulnerable in an economic slowdown. In addition, evolving approaches to security selection could help investors more objectively analyze large swaths of the credit universe and may even help increase alpha.
Adopt a balanced stance. We believe that both government bonds and credit sectors have a role to play in portfolios today. Among the most effective strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio. This pairing also helps mitigate risks outside our base-case scenario of weaker growth—such as the return of extreme inflation or an economic collapse.
Protect against inflation. We think investors should consider increasing their allocations to inflation strategies, given the heightened risk of future surges in inflation, inflation’s corrosive effect and the affordability of explicit inflation protection. In our analysis, inflation protection—currently priced at around 2.1% in the Treasury inflation-protected securities (TIPS) market—is cheap.
Consider a systematic approach. Today’s environment also increases potential alpha from security selection. Active systematic fixed-income approaches may help investors harvest these opportunities. Systematic strategies rely on a range of predictive factors, such as momentum, that are not efficiently captured through traditional investing. Because systematic approaches depend on different performance drivers, their returns may complement traditional active strategies.
Seize the Moment
We believe that active investors should prepare to take advantage of opportunities created by heightened volatility and market tailwinds in the coming months. But in our view, the most critical step is simply to get back into the bond markets so as not to miss out on today’s high yields and strong potential return.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.
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