Bond Yield Tug-of-War

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

A constant theme over the past few years has been higher‐than‐normal volatility in interest rates. The yield on 10‐year U.S. Treasury bonds is now up to 4.5%, notably higher than where it began the year at 3.8% but still below the 5.0% high seen late last year. This tug‐of‐war on the path for rates may persist going forward, as a number of factors push and pull on yields.

The biggest factor pushing yields higher is inflation. Sticky price gains have been reinforcing calls for higher‐for‐longer Fed policy. Coming into this year, the three‐month annualized percent change in the Core CPI was right around the range that the Fed would likely consider acceptable longer‐term. But that didn’t last too long, as inflation has reaccelerated in 2024. Perhaps not so coincidentally, market expectations for the number of rate cuts this year have changed considerably. Fed funds futures called for 6 – 7 rate cuts in late December but are now only calling for 1 – 2. Bond investors have repriced yields higher accordingly, with any further upside inflation risk threatening a further run up in yields.

On the flip side, one of the big events last week was the Fed meeting on Wednesday, after which the press release announced plans to pare back on the pace of its balance sheet reduction in June. The adjustment is largely technical, which is an attempt to glide the Fed’s balance sheet to levels consistent with ample reserves without overshooting the mark. That’s a moving target, with a good deal of uncertainty around it given a growing economy requires a sufficient level of reserves for managing liquidity at financial institutions. In late 2019, the Fed overtightened its balance sheet, which led to a liquidity‐driven downturn in equity markets. That’s a mistake the Fed would like to avoid repeating, hence their deliberate approach to slow things down a bit. How does this impact rates? It means the Fed may soon be a net source of demand for Treasury securities again as it lets fewer maturing bonds roll of its balance sheet.

Altogether, the upshot here for investors is in recognizing that yields have risen to more attractive levels, but the outlook for rates is actually starting to look relatively balanced from here. As a result, investors should seek to gradually move their fixed income portfolios to a neutral duration profile.

So to summarize, bond yields are up again this year, but there’s several factors at pay in the tug‐of‐war from where they go from here. Inflation pressures have been influencing rates higher, to the extent that it requires the Fed to keep rates on a tighter footing for longer. On the other side, the Fed’s revised parameters on its balance sheet runoff means the central bank may soon be a net source of demand for Treasuries. That push and pull means risks for rates going forward might be relatively balanced, but given that yields still sit at attractive levels for long‐term investors, investors should seek to gradually move their fixed income portfolios to a neutral duration profile.

Thanks for listening! And please don’t hesitate to reach out with any questions.