How Changing Interest Rates Affect Bonds | U.S. Bank (2024)

“We’ve seen rates decline on the long end of the market, which reflected that investors were less concerned about inflation surging again,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The short end of the yield curve has mostly held steady, an indication that the market remains concerned about long-term growth risks.” A primary investor focus is Federal Reserve monetary policy. While the Fed laid out a plan for three cuts to the short-term federal funds target rate it controls,² it has also indicated that it won’t rush into rate cuts without more convincing evidence of declining inflation.³

What should investors expect from the bond market for the remainder of the year and what does that say about how to incorporate or adjust strategies for fixed-income investors?

Have bond yields peaked?

Recent signals contribute to flagging inflation fears, which may have contributed to a decline in bond yields. Job growth appeared to be slowing until May, when the economy added 272,000 jobs, a significant gain from April’s report. More labor market softness was seen in the number of job openings trending lower and the unemployment rate reaching 4%, its highest level in more than two years.⁴

First quarter 2024 economic growth, as measured by Gross Domestic Product (GDP), stands at an annualized rate of 1.3% in the most recent estimate. That’s significantly softer than 2023’s final two quarters, which registered annualized GDP gains of 4.9% (third quarter) and 3.4% (4th quarter).⁵

However, inflation remains stubbornly high. The Consumer Price Index, a benchmark inflation measure, has remained above 3% over preceding 12-month periods since June 2023.4 Inflation’s persistence has investors convinced that the Fed won’t likely begin cutting short term rates (an economy-stimulating measure) until September 2024 or later.

“There’s little risk that long-term bond yields will rise dramatically from current levels,” says Haworth. “We’d have to see inflation rise again, a scenario that seems less likely based on current data trends.”

Yields remain inverted

The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on short-term bonds exceeding those of some longer-term bonds. This environment has been in place since late 2022. Under normal circ*mstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. As of June 7, 2024, 3-month Treasury bills yielded 5.52% and 2-year Treasury yields were 4.87%, compared to the 4.43% yield on the 10-year Treasury.¹

The current bond yield environment emerged after the Fed began raising the fed funds target rate in early 2022. Between March 2022 and July 2023, the Fed raised rates from near 0% to an upper range of 5.50%. The Fed’s actions were designed to temper what had been an inflation spike. Since July 2023, the Fed has held the line on further rate hikes.

“Short-term yields represented in the Treasury curve, such as the 3-month Treasury bill yields, are firmly anchored to the fed funds target rate,” says Haworth. “It’s not likely that short-term rates will meaningfully decline until the Fed begins cutting rates.”

Changing bond market

Bond yields remain significantly higher than was the case at the start of 2022, attributed to three key factors, according to Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “First is the Fed’s policy response to inflation. Second is the strength of the U.S. economy. Finally, an increasing supply of U.S. Treasury securities are coming to the market.”

“New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.

After its April 30 – May 1 meeting, Fed Chair Jerome Powell indicated that the Fed would start scaling back its bond reduction program. According to a Fed statement, beginning in June, it will “slow the pace of decline in its securities holdings” by reducing its redemption of U.S. Treasury securities from $60 billion per month to $25 billion per month.²

Inverted yield curve persists

The yield curve, representing different bond maturities, has persistently remained inverted since late 2022. Under normal circ*mstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. Many yield curve pairs using various maturities have been inverted since late 2022. This is due in large part to the Fed’s rate hikes, which have the greatest direct impact on short-term bond yields.

“New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.

As of June 1, the Fed began scaling back its bond reduction program. According to a Fed statement, it will “slow the pace of decline in its securities holdings” by reducing its redemption of U.S. Treasury securities from $60 billion per month to $25 billion per month.³ “This change signals that the Fed is somewhat comfortable maintaining a higher balance sheet of bond assets,” says Haworth. The Fed currently holds more than $7 trillion in assets, down from a peak of nearly $9 trillion reached in early 2022, but much higher than the less than $4 trillion in assets it held in September 2019.⁶

Finding opportunity in the bond market

How should investors approach fixed income markets today? In a portfolio that mixes stocks, bonds and real assets, it may be a time to modestly underweight fixed income positions. “Bond investors are most susceptible to the impacts of elevated inflation,” says Haworth. “Fixed income still plays a role, but in the current environment, investors may wish to consider scaling back bond positions given the potential for inflation remaining sticky.” Haworth says one way for investors to address inflation concerns is with a small position in Treasury Inflation Protected Securities (TIPS). “TIPS are most practical for investors with a low risk tolerance who are looking to protect their portfolios against inflation risks,” says Haworth.

Additional opportunities exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit from extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Certain non-taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. They can also incorporate long-maturity U.S. Treasury securities to manage total portfolio duration. And insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors for certain eligible investors.

Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.

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