Global bonds are coming off one of their best performances in decades as expectations swelled late last year that central banks could soon pivot to rate cuts.

 

But could a re-acceleration in inflation put this rise in jeopardy to start the new year?

 

The Q4 2023 rally caught most investors off guard, particularly in fixed income markets. The U.S. 10-year Treasury yield peaked near 5.0 % on Oct. 19, only to fall to around 3.9 % by the close of 2023.

 

A drop of that magnitude over such a short timespan has only been seen about five times dating back to 1990. It is a similar story globally as the German 10-year Bund yield ascended to a decade high of nearly 3.0 % in October, only to drop back below 2.0 % by year end.

 

The decline in sovereign bond yields helped to fuel a well-publicized rally in risk assets, with most major global stock indexes also posting historically strong rallies. All of which was largely predicated on the idea that not only have central banks well and truly reached peak policy rate levels, but that greater progress on inflation than markets expected could cause banks to pivot to modest rate cuts, and perhaps sooner than many market participants had anticipated.

 

As is usually the case, the path forward for central bank policy rates and sovereign bond yields will likely dictate the trajectory of asset class returns this year, and therein lies the near-term risk—did bond markets run too far, too fast?

 

An Early Christmas Gift

As discussed previously, RBC had projected a base case of low double-digit returns for most U.S. bond sectors, with the potential for even greater returns should the benchmark 10-year Treasury yield fade below 4.0 % by year end.

 

Unfortunately, Q4 of last year perhaps robbed 2024 of some of those returns.

 

As the chart shows, the Bloomberg U.S. Aggregate Bond Index advanced by 6.8 % as yields fell, the best quarterly performance in at least 30 years.

 

Bond prices, which move inversely to yields, jumped as a result. The average bond price in the index bounced from $86 to $92 over the course of Q4.

 

While the Federal Reserve projected three 25 basis point rate cuts this year to an implied target range of 4.50 % to 4.75 % at its December policy meeting, the market is currently priced for significantly more cuts down to an implied target range of 3.75 % to 4.00 % by year end, with a first cut potentially by the March meeting—though that is not yet our base case.

 

Given the current divergence between Fed and market rate cut expectations, broad volatility will likely remain elevated as each key piece of economic data could spark market swings one way or the other as traders gauge both the timing and extent of central bank rate cuts this year.

 

Fixed Income Exposure

Despite the recent lift in bond market performance, we still expect healthy returns in 2024 for bonds. However, we would turn slightly cautious over the near term.

 

While we strongly favored a strategy of swapping cash and short-dated securities in favor of longer-dated bonds in the back half of 2023 in order to lock in historically high yields, cash or money market funds which still offer annualized yields north of 5.0 % could be a worthwhile parking spot on a tactical basis in anticipation of more attractive entry points into longer-dated bonds.

 

Of course, investors need to be cognizant of the fact that those short-term yields will begin to fade when the Fed embarks on its rate cut journey.

 

In framing the near-term outlook, we focus on the benchmark U.S. 10-year Treasury yield.

 

Currently around 4.0 %, we view approximately 4.3 % as a potential ceiling and where we would look to put money to work should the market dial back rate cut expectations. On the downside, we see a floor for the 10-year around 3.50 % this year.

 

Economic and market optimism has pushed valuations in U.S. municipal and corporate bond markets to historically rich levels relative to comparable Treasuries. Therefore, we would also take a cautious approach for the time being to those sectors.

 

An Early Warning

The first reality check for markets in 2024 was this week’s U.S. Consumer Price Index report. On the surface, inflationary pressures rose more than Bloomberg consensus estimates had expected, but the market reaction was relatively muted regardless.

 

As Fed Chair Jerome Powell has often stated, the path back to 2 % annual inflation was always going to be a bumpy one, and the inflation data for December was perhaps one of the bumpy ones as headline inflation rose to 3.4 % year over year, up from 3.2 % annually in November—though core prices (excluding food and energy) fell to another low of 3.9 % annually.

 

Despite a slight uptick in inflation, real wages—adjusted for inflation—were shown to have increased by 0.8 % over the past year, marking the eighth month running that incomes have outpaced inflation.

 

As a result, consumers remain in a strong position to consume, which likely caused RBC Economics to boost its near-term economic outlook for the U.S., seeing Q1 GDP growth as being flat, up from minus 1.0 % previously, with the U.S. economy seen as now likely to avoid a recession again this year.

 

Baby Steps Forward

Of course, with the unemployment rate still well below 4% and inflation north of the Fed’s 2% target, it may be natural to ask why the market is even entertaining the idea of multiple rate cuts, let alone any rate cuts.

 

As the chart shows, it simply comes down to policy setting.

 

Despite an uptick in inflation last month, the trend of lower inflation is likely to remain in place.

 

RBC Capital Markets still expects further declines this year, along with comparable reductions in the Fed’s policy rate.

 

The gap between the Fed’s policy rate and the rate of inflation is the “real” rate, and that’s the rate which has actual implications for the economy.

 

 

 

The main point being that even if the Fed cuts rates multiple times this year, monetary policy may not actually be easing, as the Fed Funds would theoretically fall at a slower pace than inflation.

 

All told, we still see rate cuts on the horizon, but the road there likely won’t be without some bumps, with bond markets potentially being a near-term source of broader market volatility.

 

If you have any questions or comments, please let me know.