2024-01-04 00:56:27 ET
Summary
- Bond prices are expected to increase as interest rates decline in 2024.
- The Federal Reserve may lower benchmark interest rates depending on inflation and the health of the economy.
- Bond-focused products, such as government bonds and high-grade corporate bonds, are poised to benefit if rate cuts occur.
By Andrew Prochnow
One fundamental principle on Wall Street asserts that when interest rates decrease, bond prices tend to increase. Currently, the prevailing consensus suggests a forecast of declining interest rates in 2024. Given this scenario, bonds are becoming increasingly appealing as we approach the new year.
However, it's important to note that market forecasters do not always accurately anticipate future events. A case in point is the unexpected sharp pullback in the stock market in 2022, which was not widely predicted by analysts. Similarly, at the outset of 2023, only a few analysts foresaw the robust rally, particularly in the Nasdaq 100, that actually transpired.
That said, the bond market tends to be a bit more predictable than the stock market, especially when it hits an extreme. For example, heading into the start of the recent rate-hike cycle, many bond analysts correctly predicted that bond prices would slide as the Fed tightened U.S. monetary policy.
That's because interest rates and bond prices historically share a strong, inverse correlation. When interest rates rise, bond prices fall, which is exactly what was observed during 2022 and the much of 2023. But with interest rates poised to fall, bonds could thrive in the coming months.
At the most recent meeting of the Federal Open Market Policy ((FOMC)) - the group responsible for setting U.S. monetary policy - leaders at the Federal Reserve intimated that benchmark interest rates could get cut three times in 2024 .
Interest Rates in 2024
Whether the Federal Reserve opts to reduce rates in 2024 will heavily depend on two key factors - the persistent rate of inflation and the overall health of the underlying economy.
At the current juncture, there is an expectation that inflation will continue to moderate in early 2024. In the previous month, the U.S. consumer price index ((CPI)) decelerated to 3.1%. This marked a slight decrease from the October figure of 3.2% and remained close to the Federal Reserve's targeted inflation rate of 2%.
Crucially, the 3.2% inflation rate is significantly below the peak observed in June 2022, when the CPI surpassed 9%, as illustrated below.
Based on the aforementioned trends, one could argue that the Fed has successfully reigned in rampant inflation. Importantly, however, there's more work to be done.
The Fed can't afford to overshoot on inflation, because deflationary conditions can be just as bad for the economy as rampant inflation. As such, the Fed needs to try and "thread the needle" - ensuring that cooling inflation doesn't devolve into deflation.
The Fed is expected to try and accomplish this goal by gradually lowering benchmark interest rates, which should help foster continued growth in the underlying economy.
If the central bank is able to accomplish this feat - bringing down inflation without bringing down the economy - it will have achieved a so-called "soft landing." A term that was first conceived by former Fed Chairman Alan Greenspan, who successfully quarterbacked a soft landing in the mid-1990s, by raising and then lowering interest rates without derailing the economy.
At present, the interest rates market indicates that the Fed will cut rates by a quarter percentage point in March of 2024. That would reduce the federal funds rate from its current range of 5.25-5.50% down to a range of 5.00-5.25%.
And by July of next year, the futures market suggests that interest rates could drop to a target range of 4.25-4.50%, suggesting that the Fed will cut rates again at its meetings in June and July, as illustrated below.
Not surprisingly, many analysts on Wall Street are also expecting interest rates to decline in 2024, based heavily on the aforementioned guidance from the Federal Reserve.
For example, Morningstar recently published its 2024 outlook on interest rates, and projected that the federal funds rate could drop as low as 3.75-4.00% by the end of 2024. Importantly, Morningstar expects that downward trend to persist into the next year, forecasting that interest rates could drop to a range of 2.25-2.50% by the end of 2025.
The outlook for the Pacific Investment Management Company - often stylized as simply "PIMCO" - matches closely with Morningstar's projections. To wit, PIMCO expects 75 basis points of net cuts in 2024, which implies the federal funds rate will drop to roughly 4.50% by the end of 2024.
Obviously, there is no guarantee these projections will come to fruition. If the U.S. economy unexpectedly strengthens in H1 2024, or inflation rebounds, the Federal Reserve may be forced to keep interest rates where they are, or raise them further.
At this time, however, most projections suggest that benchmark interest rates (e.g. the federal funds rate) should drop below 5% this year, and close 2024 somewhere between 4.00-4.50%.
Bond Products to Consider in 2024
If the Federal Reserve does drop benchmark rates in 2024, bond prices are poised to benefit. In fact, it appears that some bond-focused products have already started rebounding, and could climb further if the aforementioned rate cuts materialize as expected in the coming months.
Not long ago, we suggested the iShares 20+ Year Treasury Bond ETF ( TLT ) looked attractive heading into the new year. Since bottoming at roughly $82/share in mid-October, TLT has rallied by over 19%.
TLT has clearly benefited from revised expectations for declining interest rates. And those updated expectations have also been observed in the Treasury yields market (e.g. U.S. government debt market).
Since Oct. 19, the yield on the 10-year Treasury has dropped from 4.9% all the way down to 3.9%. That's an incredible move over such a short period, and clearly illustrates that interest rates expectations have shifted dramatically.
With most signs pointing to further deterioration in interest rates, it's highly likely that other niches of the bond universe will benefit during the new year. As highlighted below, the expected returns for government bonds, aggregate bond funds, corporate bonds and high yield bonds have trended above their long-term averages.
As indicated in the above data, the current "yield-to-worst" (YTW) for each of the mentioned bond categories has risen significantly above their respective long-term averages. This presents an encouraging signal for the 2024 bond market.
Yield-to-worst serves as a forward-looking indicator, offering an estimate of the lowest potential yield for a bond by analyzing returns across various scenarios. Investors utilize yield-to-worst as a risk assessment tool to evaluate the potential downside associated with a specific bond investment.
Morningstar's data underscores that the current conditions in the bond market have converged to create a favorable situation, elevating YTW levels to highly appealing positions. This adds another reason to have a positive outlook on bonds as we approach the new year.
Nevertheless, it's crucial to recognize that financial markets inherently carry risks. If higher interest rates persist, certain corporate bond issuers may face defaults. Consequently, bond investors might opt to concentrate on higher-quality companies with established track records of meeting their financial obligations.
Corporate debt classified as "investment grade" is typically associated with financially stable and reputable organizations, considered less prone to default and, therefore, more attractive to risk-averse investors.
Two well-known ETFs that focus on high-quality corporate debt include the iShares iBoxx Investment Grade Corporate Bond ETF ( LQD ), and the iShares 5-10 Year Investment Grade Corporate Bond ETF ( IGIB ), which are both up about 5% over the last 52 weeks. Investors and traders looking for exposure to international corporate bonds can also consider the Invesco International Corporate Bond ETF ( PICB ), which is up about 10% over the last 52 weeks.
In addition to high-grade corporate bonds, investors and traders may also consider high yield bonds. High yield bonds - often referred to as "junk bonds" - are a category of corporate bonds that have credit ratings below investment grade. That means the companies issuing these bonds have a higher probability of defaulting on their interest rates, or failing to repay their principal at maturity.
Due to their elevated credit risk, high yield bonds typically offer higher potential returns as compared to investment grade corporate bonds. That said, higher yield bonds also come with higher risk, and the potential for capital losses if the issuer in question encounters financial difficulties.
Two well-known high-yield ETFs include the iShares iBoxx High Yield Corporate Bond ETF ( HYG ) and the SPDR Bloomberg High Yield Bond ETF ( JNK ), which were both up around 5% in 2023. Investors and traders interested in internationally-focused high yield bonds can also consider the iShares International High Yield Bond ETF ( HYXU ), which was up about 12% last year.
Since interest rates expectations started shifting in mid-October, all of the aforementioned bond ETFs have outperformed, as highlighted below (returns from Oct. 19 through today):
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iShares 20+ Year Treasury Bond ETF ( TLT ), +19%
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iShares iBoxx Investment Grade Corporate Bond ETF ( LQD ), +12%
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Invesco International Corporate Bond ETF ( PICB ), +10%
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iShares 5-10 Year Investment Grade Corporate Bond ETF ( IGIB ), +9%
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iShares iBoxx High Yield Corporate Bond ETF ( HYG ), +7%
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SPDR Bloomberg High Yield Bond ETF ( JNK ), +7%
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iShares International High Yield Bond ETF ( HYXU ), +7%
Considering that TLT focuses on government bonds - which are theoretically less risky than corporate bonds and high yield bonds - the above performance figures illustrate that TLT is arguably still the best bet for investors and traders that want exposure to the bond market but also want to minimize risk.
TLT tracks the performance of U.S. Treasury bonds with maturities of 20 years or more. As such, TLT provides investors with exposure to long-term U.S. government debt, which is generally considered one of the safest assets in the fixed-income universe.
On the other hand, a broadening of the bond rally could trigger significant rallies in the corporate and high yield niches of the bond market. But as explained previously, these two niches also come with additional risk. Ultimately, investors and traders need to choose the product that best matches their outlook and risk profile.
Speaking to the potential in the 2024 bond market, the chief investment officer of Blackrock's fixed income division - Rick Rieder - recently told The Wall Street Journal, "This year [2023], the traditional 60/40 portfolio was carried entirely by the stock market before this bond rally. My sense is next year [2024], fixed income will be a bigger part of portfolio return."
We tend to agree with Mr. Rieder.
Andrew Prochnow has more than 15 years of experience trading the global financial markets, including 10 years as a professional options trader. Andrew is a frequent contributor Luckbox Magazine.
For further details see:
Trading The Updated Interest Rate Outlook For 2024