Fixed Income Market Update – Q1 2024

by Mike Sanders, Head of Fixed Income

The first quarter of 2024 ended with a reversal of mood from the final quarter of 2023. As December wound to a close, Treasury yields moved sharply lower in anticipation of a faster and more aggressive shift toward monetary policy easing. However, as economic data continued to paint a resilient domestic economy on a canvas of stubbornly persistent inflation, the market soured on the thought of six (!) rate cuts in 2024. Yields have since retraced much of that late-2023 rally and pushed expected policy easing further into the future.

The End is Here, Now What?

The Federal Reserve (Fed) and the bond market finally seem to agree that the tightening cycle that began in 2022 is likely to end and switch to easing sometime in 2024. Comments by Fed Chairman Jerome Powell suggest that the Federal Open Market Committee (FOMC) has actively discussed a timeline for lowering interest rates. However, the two primary drivers of Fed policy, employment and inflation, continue to speak to delaying any such decision. With each month of inflation exceeding expectations, the Fed’s 2% long-term price target seems more and more out of reach. And a strong labor market only strengthens the argument for keeping rates steady.

As markets scrutinize every data release in search of insights into future policy direction, the Fed finds itself having to navigate the risks of waiting too long to ease conditions (risking unnecessary pain to the economy) and moving too soon (risking stoking inflationary pressures). The much anticipated “soft landing” that market participants once thought impossible seems to be increasingly present in market data. From here, the Fed will be challenged to navigate the final “descent” toward policy easing in a volatile economic environment.

The Fed Remains Patient

Stronger economic data, a higher projected long-term Fed Funds rate, and “higher for longer” commentary from Fed speakers pushed yields higher during the first quarter. 2-year, 10-year, and 30-year Treasury yields rose by 37, 32, and 31 basis points (bps) to 4.62%, 4.20%, and 4.34%, respectively. The rise in market rates resulted in negative total returns, with the Bloomberg U.S. Treasury Index returning -0.96% during the quarter.

Q1 2024 FI Treasury Curve Chart

Current market pricing projects three cuts in 2024, more in line with stated Fed projections of 75 bps starting as early as June. As the market has retraced much of the late-2023 rally and come back into line with current Fed projections, value has returned to fixed income markets. While continued rate volatility is likely as investors seek visibility on the path of policy, current yields offer an attractive entry point with reduced risk of upward rate movement. From here, any material deterioration in economic growth would threaten the current ‘soft landing’ prospect built into consensus rate expectations.

Soft Landing Continues to Support Risk Assets

All corporate bond sectors (Industrials, Financials, and Utilities) performed well during the quarter, with Financials leading the way. On a total return basis, Financials outperformed Industrials and Utilities due to a combination of tighter credit spreads and having less duration in a rising rate environment. Lower quality (BBB) and shorter-term corporate bonds outperformed higher quality and longer-term corporate bonds during the quarter. The Bloomberg U.S. Industrial Index returned -0.77% during the quarter, while the Bloomberg U.S. Financial Index returned 0.35%. Lower quality continued to outperform higher quality, with the Bloomberg U.S. Credit Baa-rated Index returning 1.06% better than similar maturity Treasuries, outperforming A-rated bonds. Even though credit spreads are not quite as attractive as in recent years, investor demand for corporate bonds remains solid, especially with yields comparing favorably to equity dividend yields.

Q1 2024 FI Corporate Yields

Should the economic ‘soft landing’ play out as expected, credit assets will continue to do well. However, by most measures, current spreads on credit sensitive assets offer limited upside to further tightening, and if the economy slows, spreads could be at risk of widening.

Positioning and Outlook

While we welcome the market repricing of Fed easing expectations, we remain wary of how financial markets have adopted an economic ‘soft landing’ as a foregone conclusion. We have entered a new phase of monetary policy, and the Fed’s ability to continue pushing inflation lower without economic damage will likely be more challenging than markets are estimating. Strong labor markets and stable economic data are giving the Fed room to remain patient, but economic headwinds could pose a challenge, which could alter that landscape in the coming months. Rising rates in recent months have resulted in attractive valuations returning to fixed income markets, providing meaningful yield with less risk of further upward rate movement. We expect further yield declines will be dictated by changing economic fundamentals and stand ready to take advantage of market volatility as expectations for monetary policy adjust in the months ahead.

We continue to believe that an eventual easing of interest rates will ultimately benefit the “belly” of the yield curve – the intermediate range of 3-7 years – more than longer term bonds. As Fed policy tends to dictate short term bond yields and long-term growth and inflation expectations dictate longer-term bond yields, we are more confident in the former moving lower in the next 12 months. In fact, should the recent uptick in inflation persist and rates stay higher for longer, we could see the 10-year Treasury move higher from its current level.

We anticipate this cutting cycle will look very different from previous cycles when the Fed cut all the way down to zero. In a more typical cycle, with a higher r-star (longer-term neutral rate), absolute fixed income yields across the curve should remain attractive.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

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The Bloomberg U.S. Finance Corporate Bond Index is a subset of the Bloomberg U.S. Corporate Index that measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate bonds of financial institutions.

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In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk, credit risk and inflation risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Credit risk is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.

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