2023 was supposed to be the year of the bond – and while returns have been positive, broadly reflecting income from the bonds, a strong capital uplift from a decline in yields was less forthcoming. So, with interest rates arguably peaking, what caused the delay and where do yields go from here?

A bump in the road

Back in early October 2023 we discussed the phenomenon of a ‘bond bear steepener’ that was taking place. This is where yields on longer term bonds rise more than the rise on shorter dated bonds. It is called a steepener because the yield curve that plots yields of bonds of the same quality but different time to maturity is normally upward-sloping from bottom-left to top-right. So, if yields on longer dated bonds rise faster than on shorter dated bonds this would cause the yield curve to steepen. We explained that a bond bear steepener was a very rare occurrence and when it took place when yield curves were inverted – as was the case in 2023 – it typically led to 1) a fall from peak yields and 2) the onset of a recession.

As if on cue, yields began to fall throughout November and December, undoing much of the rise in yields during 2023, but not far enough to deliver the capital gains we had expected. But that was 2023. Can yields decline further in 2024 and will the second part of the historical pattern hold, i.e. will a recession take place?

Different route, same destination

History may offer a valuable lesson. First, let’s agree that the July 2023 hike by the US Federal Reserve (Fed) was the final hike (or terminal rate in central bank parlance) in the current rate cycle. This seems a reasonable assumption given the remarkable pace of core disinflation now evident. We can then plot the change in the US 10-year Treasury yield before and after the last hike (as shown in Figure 1), with 0 representing the point of the last hike.

Recall that a rise in yields leads to a fall in bond prices and vice versa, so a declining line would indicate falling yields and rising bond prices. We compare this with how yields responded on average every time the Fed finished hiking rates in the 1969-81 period (characterised by rising and high inflation) and the 1984-2018 period (characterised by declining or low inflation). Overlaying the most recent 2023 episode shows that yields have followed the 1969-81 behaviour rather than 1984-2018 average.

This is interesting because it sets up potentially strong returns for bonds over the next 12-18 months regardless of which path is followed. Yet the outcome over the next six months or so could be very different:

• Frustrating near-term bond bear market: Yields follow the orange 1969-81 path. This would see them range bound for a significant part of 2024 – anything that reignites inflationary concerns or a temporary re-acceleration of growth that leads to central banks pushing back rate cuts might cause this. The longer spell of high interest rates tightens financial conditions and the economy weakens in the second half of 2024, inflation fears subside and rate cuts loom large, prompting a sharp decline in bond yields later in 2024.
• Steady bond bull market: Yields reconnect with the blue 1984-2018 path and bond yields steadily decline. This could happen if it becomes clear that inflation is firmly defeated. Central banks embark on rate cuts to prevent real rates (interest rates minus the inflation rate) becoming too restrictive.

Of course, bond yields may take an entirely new path that resembles neither of the above. While that may be the case, we reckon the general direction for yields in 2024 is lower. In our view, it seems unfeasible that the lags from earlier monetary tightening do not weigh on economic growth. We still see a high probability of a US downturn in 2024 and some European countries are already flirting with recession. Remember that even if central banks start the process of cutting rates, most companies or households that are refinancing debt or mortgages will be paying a higher rate of interest than was the case a few years ago. Policy will still be restrictive and if inflation is lower it means real (adjusted for inflation) rates are more punitive.

That is why when the Fed starts to cut, it tends to do so quickly. Interest rates rarely plateau for long. In fact, over the last 70 years the average plateau was six months. So, were a cut to occur in March 2024 – a plateau of eight months since the July 2023 hike – this would be broadly in line with the average cycle.

Synchronised easing

The hiking cycle among developed market central banks was synchronised, with most banks raising interest rates within a few months of each other. We expect the same to happen with cuts. We therefore think that 2024 should potentially offer the returns we expected in 2023, with a combination of income and capital gain from government bonds as yields decline.

Within credit, we believe that agency mortgage-backed securities potentially offer attractions, both for their income and their relatively low credit risk in being backed by federal agencies or the US government directly. We are also starting to view BB-rated high yield corporate bonds as almost a distinct asset class – it is becoming a repository for growth companies with improving cash flows, while several BBB-rated investment grade bonds, particularly among telecoms, are legacy companies saddled with high debt. Economic weakness means greater care may need to be taken when selecting among corporate credits.

In summary, the next few months could see bond yields taking different paths, but we ultimately expect a combination of income and declining rates to lead to attractive returns from bonds in 2024.

IMPORTANT INFORMATION

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Mortgage-backed securities (MBS) may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns