Bonds are back in the black!

Bond returns likely end 2023 & 2024 in the black! Entering this year, we felt the Fed was nearing the end of its tightening cycle, inflation would decline to have a 3% “handle” and Treasury yields would decline. The first two predictions turned out well. Not so for the third. Treasury yields have risen this year, and in mid-October they hit their highest levels in 16 years, pushing year-to-date bond returns at that time into the red. Fortunately, Treasury yields have dropped since on signs of continued disinflation, decelerating U.S. growth and rising prospects of Fed easing in 2024. This price action produced strong, positive returns for November and put year-to-date total returns back in the black. Can the rally continue in 2024? We think it can, but to a modest degree. Risks going forward have become symmetric. The U.S. economy appears to be slowing and generating less inflation, while the federal government’s massive borrowing needs continue to grow at a time when the Fed is shrinking its balance sheet. On net, we expect Treasury yields to remain range-bound in the near term and to decline modestly next year. If we are right, expect mid-single-digit positive total returns for U.S. Treasury securities, supported by the 4.40% yield on the U.S. Treasury Index plus some price gains.

Powell & company will walk slowly on the easing path The market is now priced for 100 basis points of Fed easing over the next year and the first cut in spring 2024. That seems excessive. Policymakers’ focus on securing the not-yet-complete win against inflation suggests the Fed will move slowly. Labor market data would need to deteriorate sharply (with initial claims rising rapidly, nonfarm payrolls falling far below 100k per month and/or the jobless rate rising well above 4%) for the Powell-led FOMC to match market easing expectations. Short of the now-consensus soft landing becoming a hard one (a risk which we aren’t ruling out), we expect FOMC members will reinforce their higher-for-longer mantra and their dedication to the 2% inflation target.

Questions about America’s fiscal trajectory Winners of the 2024 election for the White House and control of the Congress will face not only a large and rising deficit, but also the sunset of the Trump tax cuts at year-end 2025. If allowed to occur, this sunset will drive income tax rates up (e.g., the top tax federal bracket rising from 37% to 39.6%). With U.S. federal debt to GDP now greater than 100% for the first time since post World War II, the bond market focused on the impact of rising Treasury supply and the U.S. Government now rated below AAA by two of the three major ratings agencies, the tax and spending decisions of the election winners may have significant bond market consequences.