How Changing Interest Rates Affect Bonds | U.S. Bank (2024)

Federal Reserve monetary policy remains top-of-mind for bond investors. While the Fed laid out a plan for three cuts to the short-term federal funds target rate it controls,¹ it has also indicated that it won’t rush into rate cuts without more convincing evidence of declining inflation.²

In April, yields on the benchmark 10-year U.S. Treasury note jumped 0.5%, peaking at 4.7%, before retreating to around 4.5% in early May.³ A weaker-than-expected April jobs report, showing the economy added a modest 175,000 jobs,⁴ pushed bond yields lower as investors saw it as a sign favoring Fed interest rate cuts. It’s not clear yet, however, when exactly the Fed might start making such cuts.

“Economic growth remains solid, which might indicate interest rates need to remain elevated for some time,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The most recent data indicates inflation may linger higher for longer, and we’re also seeing foreign buyers stepping back from the U.S. market. Both factors contribute to keeping bond yields higher as well.”

Bond yields jumped in April in the wake of a government report showing that inflation, for the 12-month period ending in March 2024, rose to 3.5%, its highest level since September 2023.⁴ After topping out at 4.98% in October 2023, 10-year Treasury yields dropped below 4%, but trended higher over the course of 2024, with modest up-and-down-movements.³

The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on short-term bonds exceeding those of some longer-term bonds. For example, as of May 3, 2024, 3-month Treasury bills yielded 5.45% and 2-year Treasury yields were 4.81%, compared to the 4.50% yield on the 10-year Treasury.³ The Fed is keeping the door open to potential federal funds target rate cuts later in the year, but investors should still prepare for the possibility that the timeline for the start of Fed rate cuts may be pushed further out.

The current bond yield environment emerged after the Fed began raising the fed funds target rate in early 2022. Between March 2022 and July 2023, the Fed raised rates eleven times, from near 0% to an upper range of 5.50%. The Fed’s actions were designed to temper what had been an inflation spike. Since July 2023, the Fed has held the line on further rate hikes.

“If the Fed cuts short-term interest rates, yields on shorter-term debt issues are likely to decline,” says Haworth. “The upward movement we’ve seen in bond yields this year reflects markets getting well ahead of expectations for 2024 Fed rate cuts,” says Haworth.

What should investors expect from the bond market for the remainder of the year and what does that say about how to incorporate or adjust strategies for fixed-income investors?

Changing bond market

Despite the recent decline in bond yields, they remain significantly higher than was the case at the start of 2022. “Three key factors drove the jump in bond yields,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “First is the Fed’s policy response to inflation. Second is the strength of the U.S. economy. Finally, there is an increasing supply of U.S. Treasury securities coming to the market.”

“New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.

After its April 30 – May 1 meeting, Fed Chair Jerome Powell indicated that the Fed would start scaling back its bond reduction program. According to a Fed statement, beginning in June, it will “slow the pace of decline in its securities holdings” by reducing its redemption of U.S. Treasury securities from $60 billion per month to $25 billion per month.²

Inverted yield curve persists

The yield curve, representing different bond maturities, has persistently remained inverted since late 2022. Under normal circ*mstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. Many yield curve pairs using various maturities have been inverted since late 2022. This is due in large part to the Fed’s rate hikes, which have the greatest direct impact on short-term bond yields.

Haworth notes that in recent months, the inverted curve has flattened a bit. “Yields are still higher on one-month to two-year Treasuries, but the curve is relatively flat from the five-year level on up.” Haworth says a major question is how the inverted yield curve scenario is resolved. “If shorter-term yields come down to normalize the curve, it will reflect the Fed achieving its inflation-fighting goals. If the curve normalizes because long-term rates go higher, it likely means inflation remains elevated, which results in other challenges for the Fed and investors.”

Finding opportunity in the bond market

How should investors approach fixed income markets today? In a portfolio that mixes stocks, bonds and real assets, it may be a time to modestly underweight fixed income positions. “Bond investors are most susceptible to the impacts of elevated inflation,” says Haworth. “Fixed income still plays a role, but in the current environment, investors may wish to consider scaling back bond positions given the potential for inflation remaining sticky.” Haworth says one way for investors to address inflation concerns is with a small position in Treasury Inflation Protected Securities (TIPS). “TIPS are most practical for investors with a low risk tolerance who are looking to protect their portfolios against inflation risks,” says Haworth.

Despite the appeal of short-term bonds paying higher yields, Merz says investors with a long-term time horizons are well served by building diversified portfolios designed to generate competitive returns over time. “It’s time to take money that was shifted away from appropriate bond allocations during the period of historically low interest rates to gradually move money into longer-term bonds. Longer-term bond yields remain far more compelling today than they have been in years.” Merz says for conservative investors, “It’s possible to generate reasonably attractive returns in a mix of bonds without extending their risk budget.”

Additional opportunities exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit from extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Certain non-taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. They can also incorporate long-maturity U.S. Treasury securities to manage total portfolio duration. And insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors for certain eligible investors.

Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.

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