The Path Forward | Fixed Income Update

Trajectory is the path an object follows under the action of given forces. It can be described as a progression, a flight path, or a charted course. As for financial markets, investors prefer clarity and when faced with changing conditions we see a pickup in volatility.

Interest rates over the past 18 months have experienced historically high levels of turbulence. We saw bond prices rise and yields fall as consensus pointed to lower future interest rates, slower economic growth, and a possible recession. However, in recent quarters we experienced the exact opposite: bond prices fell, interest rates rose, and economic growth expanded. This turnaround in trend has been sparked by lingering inflation data and impressive economic growth figures. With such a zig-zagged path over the past year, it’s easy to wonder where we go from here. A clue to this may lie in the shape of the yield curve.

Yield Curve Predictions

The yield curve is a graph plotting the yields on various durations of treasury bonds – it spans a 1-month note all the way out to a 30-year bond. A normal yield curve positively slopes upward – meaning short- term rates are lower than long-term rates, and the market compensates investors for the risk of investing for a longer time period. The image below helps illustrate this data from April 26, 2017.

An inverted yield curve flips this and can be concerning for a few reasons. Why would short term rates be higher than longer term ones? Oftentimes, we see this phenomenon occur when the market “prices in” Fed rate cuts on the horizon, which can occur when the Fed is put in a situation that requires economic stimulus (such as the Covid pandemic). Today’s yield curve is inverted, as evidenced below, but it’s still unclear what exactly will inspire the Fed to initiate rate cuts, or if they actually need to do so given such strong economic and corporate profit data.

The current yield curve inversion is unprecedented. The curve has been inverted since 2022, a record length of time. Today's 2+ year inversion exceeds the previous record, a 624-day inversion that was observed in 1978. However, there is evidence that we are still moving in the right direction. Take the difference in yield between a shorter-term 2-year bond and a longer-term 10-year bond, a measurement of the curve’s steepness: this gap has been closing, suggesting we are inching closer to a more normal environment, and we expect this flattening to continue.

Since the beginning of the year, market expectations of six Fed rate cuts by the end of 2024 have been radically reduced. Currently, the market is now only expecting one or two rate cuts as growth continues to support a more ‘normal’ interest rate environment. For those old enough to remember, or who have lived through 1970-2009, today’s interest rates are not high by historical standards

Understanding a New Trajectory

Rates are at the highest they have been in years, but our research suggests that the probability of a rate hike is far less likely than a rate cut. Data suggests that we are still in a “window of opportunity” to lock in current yields. Although we will likely see mild rate cuts in the near future, we also are unlikely to return to the 0-3% hallmark of the previous decade plus. Again, we suspect that the ability to find 4-5% yields will be rare in the coming years and wise investors will seize the moment.

When the Fed begins cutting rates, the most at-risk bond investors will be those who only own short- term bonds, which have significant reinvestment risk in a declining interest rate environment. Money market funds, for example, move alongside the Fed funds rate, and investors with outsized balances in this asset class will need to find a new home for their capital if they continue to expect over 5% yield. If you have large holdings in short-term investments or money market funds, we recommend speaking with your advisor to understand the considerations related to longer duration fixed income investments.

We believe it’s a great time to be locking in rates and adding individual bonds to your portfolio. Corporate balance sheets are strong, we are near the peak of the interest rate cycle, and there are still opportunities to capitalize by locking in rates for longer. We take pride in our credit research, custom bond ladders, and tactical rotation. Our approach to locking in yields for years to come can help keep you on the right path to reaching your financial planning goals. We are excited to continue to do this for you, your family, and your friends, no matter the future trajectory.

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Thank you again for your continued vote of confidence in our work,

Your Team at Main Street Research

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