By Davide Barbuscia
NEW YORK (Reuters) -As bonds emerge from a historic selloff, some investors expect better times in the U.S. fixed income market next year - as long as the Federal Reserve’s rate cuts play out as anticipated.
A fourth-quarter rally saved bonds from an unprecedented third straight annual loss in 2023, following the worst-ever decline a year earlier. The late year surge came after Treasuries hit their lowest level since 2007 in October.
The year-to-date total return for the Morningstar US Core Bond TR USD index, which tracks U.S. dollar-denominated securities with maturities greater than one year, was 5.47% as of this week, up from about minus 13% last year.
Fueling those gains were expectations that the Fed is likely finished with rate increases and will cut borrowing costs next year - a view that gained traction when policymakers unexpectedly penciled in 75 basis points of easing in their December economic projections amid signs that inflation continued to cool.
Falling rates are expected to guide Treasury yields lower and push up bond prices - an outcome that a broad swathe of investors are anticipating. The latest fund manager survey from BofA Global Research showed investors are holding their biggest overweight position in bonds since 2009.
Still, few believe the path to lower yields will be a smooth one. Some worry the over 100 basis point drop in Treasury yields since October already reflects expectations for rate cuts, leaving markets vulnerable to snap backs if the Fed doesn’t cut soon enough or fast enough.
The market has priced some 150 basis points in cuts next year, twice what policymakers have penciled in, futures tied to the Fed’s main policy rate show. Benchmark 10-year Treasury yields stood at 3.87% on Friday, after hitting their lowest level since July earlier this week.
Many are also watchful for the return of the fiscal worries that helped drive yields to their 2023 peaks but ebbed in the later part of the year.
“As long as the Fed doesn't totally have this wrong, we should expect to see some rate cuts next year,” said Brandon Swensen, a senior portfolio manager on the BlueBay Fixed Income team at RBC Global Asset Management. However, “it could be a bumpy path."
‘BONDS ARE BACK’
The late-year rebound in fixed income has bolstered the confidence of fund managers.
"Bonds are back," Vanguard said in an outlook report published earlier this month.
The world's second largest asset manager expects U.S. bonds to return 4.8%-5.8% over the next decade, compared with the 1.5%–2.5% it expected before the rate-hiking cycle began last year.
Year-to-date, the Vanguard Total Bond Market Index Fund, with over $300 billion in assets, posted a 5.67% return, up from negative 13.16% last year. PIMCO's flagship $132 billion bond fund, the Income Fund, had year-to-date returns of 9.25% from minus 7.81% last year.
Though not everyone sees a recession ahead, most bond bulls are counting on slowing U.S. economic growth and ebbing inflation to push the Fed to cut interest rates.
Eoin Walsh, partner and portfolio manager at TwentyFour Asset Management, said 2023’s rise in yields means fixed income can offer the best of both worlds - income with the potential of capital appreciation.
“From where we are right now, you are going to get your yield on Treasuries and you probably will get a capital gain as well,” he said.
He expects 10-year yields to be between 3.5% and 3.75% by the end of next year.
Others believe some parts of the Treasury yield curve may have already rallied too far.
Rick Rieder, chief investment officer of global fixed income at BlackRock (NYSE:BLK), said the recent rally has left both longer-dated and shorter-dated bonds “quite rich.” “Much of the 2024 return for the very front end and for the very back end … has already been achieved," he said.
At the same time, concerns over wide fiscal deficits and expectations of increased bond supply could boost term premiums - or the compensation investors demand for the risk of holding long-term bonds. Meanwhile, demand could lag as the Fed and large foreign buyers such as China trim their Treasuries holdings.
The recent bond rally has also eased financial conditions, a measure of the availability of funding in an economy. Some worry that could fuel a rebound in growth or even inflation, delaying the Fed's rate cuts.
The Goldman Sachs Financial Conditions Index has fallen by about 150 basis points since late October and this week stood at its lowest level since August 2022.
"The more markets move to price in cuts, the less urgency the Fed should probably feel about delivering them, because the markets are doing the easing for them," said Jeremy Schwartz, U.S. economist at Nomura.