Is the Bond Market Broken?

Lawrence Gillum:

The Federal Reserve cut interest rates last September, and to date, the central bank has lowered rates by 1%, but over the same time period, long-term Treasury yields are higher by nearly 1%. Additionally, the economic data has been coming in weaker-than-expected, which usually means interest rates move lower as well. They haven't. So in this edition of the LPL Street View, we unpacked the recent price action in the Treasury market and asked the question, is the bond market broken? After enduring the most aggressive rate hiking cycle in decades? Fixed income investors were likely thinking it would be an easy road to lower yields and higher prices once the feds started cutting interest rates. Unfortunately, that hasn't happened. In fact, the opposite has happened since the Fed started cutting rates last September, the fed funds rate is lower by 1%, but at the same time, the 10-year Treasury yield is higher by nearly 1%.

Lawrence Gillum:

This chart by Bianca Research highlights the unusual reaction of the 10-year Treasury yield after the first rate cut only 1981. At the heights of the highest inflationary pressures ever here in the U.S. did the 10-year yield move higher than the recent move as highlighted During rate-cutting campaigns, long-term yields tend to drop, not rise. Making this recent move higher in yields even more particular, is that the economic data has been coming in weaker-than-expected. This chart highlights the Bloomberg Economic Surprise Index, which is an index that measures the difference between actual economic data and the median forecast from Bloomberg surveys of economists. When the economic data comes in better than forecast, the index value rises and vice versa. Moreover, when the index's direction changes, you tend to get a change in direction in Treasury yields as well, that is the index and Treasury yields are positively correlated.

Lawrence Gillum:

So while the economic surprise index had been showing positive strength during the fourth quarter, the index has recently turned negative. Meaning economists are currently overestimating the strength of the economy, but Treasury yields have continued to move higher. That doesn't typically happen either. So what gives? Well, investors have started to demand higher-yields to own longer maturities securities, which is currently offsetting concerns about the economy. Alright, so stay with me here. This is where things get wonky but important. According to economic theory, each security on the Treasury yield curve represents the expected fed funds rate over the securities maturity, plus or minus a term premium. The term premium is the additional compensation required by investors who buy longer-term Treasury securities. The term premium, which is unobservable and hence must be approximated, considers a variety of factors including Treasury supplied demand dynamics, foreign central bank expectations, and the possibility of future inflationary pressures.

Lawrence Gillum:

And after years of negative term premium, investors are just now getting compensated for owning longer maturity Treasury securities. But that additional compensation is still below longer-term averages. And as long as the economic data doesn't collapse, we're likely going to continue to see the potential for still higher long-term bond yields. And while monetary policy expectations will continue to be the dominant driver of interest rate changes, unless or until economic data weakens sufficiently to price in more fed rate cuts, longer-term interest rates may need to stay elevated to continue to attract demand. So how does this affect fixed income investors? Besides stubbornly, high bond yields a positive and growing term premium could keep longer-term interest rates elevated, perhaps even reducing the diversification benefits of core bonds. While we still believe Treasury securities will be the safe haven choice, in the case of a broad macro equity market sell-off, they may not be the best of defensive option for garden variety equity market sell-offs.

Lawrence Gillum:

And if we assume things get back to normal and the Fed sticks the soft landing, we could see that term premium increase back to long-term averages. So despite the recent move higher in yields, we still don't think right now is a good time to overweight duration in fixed income portfolios. A neutral duration relative to benchmarks is, in our view, still appropriate. And for those investors that want to own bonds for income, the belly of the curve out to call it five years remains attractive. That's all for now, and if you want more insights on global market trends, follow us on social media and thanks for listening.