Despite the resilience of the American economy, investors in Treasuries and bonds harbor stiff hopes for a quick Fed pivot during the third losing year. “But we aren’t there just yet,” said Fidelity’s global fixed income CIO Steve Ellis.
Treasury investors are once again losing money following the hikes in interest rates. United States government bonds are poised to register an average 42 percent decrease over the past three years. Some 30-year bonds have lost more than half of their value, leaving investors grappling with unexpected losses from assets that were traditionally perceived as ultra-safe anchors within a diversified portfolio.
It is however “time to stop crying about bonds and buy them instead,” Barron’s editor Daren Fonda wrote last weekend, echoing an oft-repeated mantra from asset managers who have been hoping for a pivot in Federal Reserve interest rate policy for months.
Vanguard sees ‘new era’
Bullish asset managers, such as Pimco and AllianzGI, have been arguing for months that the market environment represents an attractive entry point not seen in recent years. Blackrock, Janus Henderson, and Vanguard have, among others, recently joined the group of bond advocates.
“Investors came into this year expecting a recession, and instead saw a surprisingly robust economy. As we look to 2024, we expect those conditions to change. Investors expecting a repeat of 2023 may be surprised again,” Vanguard said in a fixed income note last week. “We believe we are in a new era for fixed income in which bonds offer significantly more value—both in total returns and as better ballast within an overall portfolio.”
Most US treasury yields currently hover around the level of 5 percent, their loftiest levels since 2007, closely aligning with the very long-term average yield on 10-year treasuries dating back to 1790. In fact, yields are so high that there is no premium for taking extra risk by investing in emerging-market bonds, an investment that usually yields 200 to 300 basis points more than US treasuries.
‘The Fed is done’
The optimism surrounding bonds is grounded in the belief that the Federal Reserve has concluded its rate-hiking cycle and is now poised to cut rates. In this scenario, U.S. treasuries are seen as the sweet spot, as yields will come down, and prices will rise.
“The Federal Reserve is done,” said Frank Dixmier, Global CIO fixed income at AllianzGI. “A recession has been postponed, as growth keeps surprising, but our analysis of consumption in the US supports the idea that the country will soon enter a recession,” says Dixmier, who has been buying treasuries with a duration between two and ten years since the summer. These “should benefit from the first rate cuts in mid-2024 and the steepening of the yield curve”, he said.
The futures market is currently indicating two to three interest rate cuts by the end of next year. That, however, is significantly less than an earlier market expectation of four to five rate cuts, which was prevalent as recently as early September.
Reduced Appetite
Despite the praise for current market conditions, overall demand for the belly of the curve has not proven strong enough to stabilise the price of US government bonds. The Federal Reserve has been reducing its bond holdings as it unwinds its pandemic-era stimulus measures, and traditional buyers of treasuries like China and Japan have scaled back their bond acquisitions, further contributing to the reduced appetite.
The market currently demands 100 basis points more interest on 10-year U.S. government bonds than just after the Federal Reserve’s last rate hike on July 26, indicating that the fear of a recession - the requirement for rate cuts - has not materialised yet.
Outperforming economy
Inflation is still above the target at 3.7 percent, and the American economic growth stood at a robust 4.9 percent for the third quarter on an annualized basis, surpassing the expected 4.5 percent.
One of the main drivers of growth is the American consumer, according to Whitehouse.gov, a US government website. Consumer spending makes up two-thirds of the US economy on average. Real consumption spending grew almost 2 percentage points more than expected at this time last year, “so as the U.S. consumer goes, so goes the U.S. economy,” the website states in its economy blog on Monday.
This phenomenon was propelled by the labor market performance, which showed an unemployment rate of 3.7 percent in the third quarter, a notable deviation from the anticipated 4.4 percent.
“We are still heading towards a downturn, one that should slash inflation, demand a pivot of some kind from the Fed, and create a turning point for bond markets,” said Fidelity’s global fixed income CIO Steve Ellis, “but we aren’t there just yet.”
Discounting of bonds still supported
Ellis: “We are discovering again that bonds are not functioning as an equity diversifier. There is and will be demand for them, but it will come at a price. The US is suffering from endemic fiscal deficits, and rising interest costs only add to the headline deficit. The fiscal trends are unsustainable, and that’s before we confront what could still turn out to be a hard recession next year. That all supports the market’s current discounting of bond prices.”
On Wednesday, when the Federal Open Markets Committee (FOMC) is poised to keep the funds target rate unchanged in the range of 5.25 percent to 5.50 percent, the forthcoming quarterly refunding announcement will unveil the Treasury’s strategy for increasing the issuance of longer-term debt in order to finance a growing budget deficit.
Investors who hold on to US government bonds can reasonably expect to receive their initial principal upon maturity. However, in doing so, they must grapple with a significant opportunity cost, as their funds remain locked up for extended periods, typically spanning 10 to 30 years, all in pursuit of what Jonathan Boyar, managing director at Boyar Asset Management, expects to be “just a few measly additional basis points in yield.”