Systematic Fixed Income Outlook: Navigating the (new) conundrum

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Key points

• The Fed pause that gives pause: Stronger-than-expected inflation and labor market data into the end of 2024 led to the US Federal Reserve's (“Fed’s”) decision to pause interest rate cuts. Easier financial conditions, along with positive real wage growth, have bolstered wealth and consumer spending. These dynamics have reduced the impact of higher interest rates on the real economy relative to historical cycles, so far requiring less normalization than policymakers previously expected.
• Policy uncertainty trumps macro uncertainty: Fears of a recession induced by tight monetary policy have continued to fade with signs of persistent economic strength. Market focus has shifted to governmental policy uncertainty as investors weigh possible changes to be implemented by the new administration, with the biggest areas of focus being potential negative surprises from trade and immigration policies and potential positive surprises related to taxes and deregulation.
• Navigating the (new) conundrum: Our prediction for a “new conundrum” played out in 2024 as long-end yields moved higher despite the start of interest rate cuts—going against the “bonds are back” consensus narrative. For 2025, the potential for further steepening reinforces the importance of where you hold your duration, with the short-end and belly of the curve appearing most attractive.

Navigating the (new) conundrum

2024 marked yet another year of hoping bonds would be back, only to be disappointed by another subpar (and in this case sub-cash) return year. We instead saw our prediction of a “new conundrum” realized as the Fed cut interest rates by 100bps, only to see 10-year yields rise by 100bps. The name references the opposite of the of the conundrum coined by former Fed Chair Greenspan during the 2004-2005 hiking cycle when long-term rates trended lower despite higher policy rates.

While these moves following the Fed’s initial cut partly reflected an unwind of earlier rate declines (in a “buy the rumor, sell the news” fashion), 10-year rates ended up over 50bps for the year despite the start of the cutting cycle.

The “bonds are back” consensus view was to buy bonds when the Fed is cutting rates. Yet our “new conundrum” thesis highlighted the vulnerability in this outlook: where you hold your duration matters as much as how much duration you hold. In other words, where you hold your interest rate exposure—short, intermediate, long—mattered a lot in 2024. Considering that 2-year yields were relatively unchanged, 5-year yields were up 54bps, 10-year yields were up nearly 70bps, and 30-year yields were up 75bps, total return performance across the curve varied widely.

Where you hold your duration matters as much as how much duration you hold

For 2025, the outlook for performance across the curve has evolved from last year as interest rate cuts normalized the curve shape from inverted to slightly upward sloping as shown below. That has restored some value to moving out on the curve from cash, as cash yields are no longer the highest yields. It also means that duration equivalent front-end exposures are no longer as prohibitively expensive from an annual income perspective as they were when the curve was inverted. That becomes important when we turn to another key reason to hold treasuries in a portfolio besides income—which is hedge effectiveness.

Not your father’s bond market

Investors hold bonds for income, price appreciation, and ballast. Much of the excitement around “bonds are back” in 2023 stemmed from income being back, and in 2024 from price appreciation being back with anticipated interest rate cuts. The “new conundrum” frustrated that expectation for price appreciation. That leaves ballast—the expectation that bonds will go up when stocks go down—as the final reason for holding bonds in a portfolio. However, the steepening of the yield curve and prospects for more steepening in 2025 reinforces the importance of where you hold duration along the curve.

Consider the performance of ballast by bond maturity in Figure 8. We measure the degree of ballast by looking at the stock-bond correlation (“SBC”) at different maturity points along the curve. The more negative the SBC, the more we can expect bonds to respond positively to negative “risk-off” shocks.

The below chart highlights that the strongest response in terms of inverse movements in yield relative to stock returns has been at the short-end of the yield curve. This follows the more recent elevated level of Fed policy rates implying a substantial amount of room for short-term yields to decline, coupled with a shift in Fed policy away from the use of the balance sheet for accommodation that was so prevalent during the post-Great Financial Crisis (“GFC”) period. Today, “flight to quality” is led by short rather than the long maturities as was the case during the zero interest-rate policy and quantitative easing period following most of the GFC. An upwardly sloped curve for 2025 additionally means less punitive hedging costs when making a transition away from a long maturity exposure into a short maturity exposure on a duration equivalent basis.

Term premia steepening additionally drove underperformance of longer maturities in 2024. That term premia increase reflects a normalization from post-GFC low levels driven by the proximity to the zero lower bound, the inability of central banks globally to achieve their inflation targets (too little inflation), and an increase in inflation volatility post-COVID increasing inflation term premia.

Estimates of term premia, such as the one above, highlight increases off the lows, but also the potential for further room to expand relative to history. Treasury issuance will remain in focus as uncertainty surrounding the fiscal outlook likely impacts term premia and yields—the risk being a more permanent increase in deficits requiring greater long-term debt issuance pushing up the term premium. A more significant increase in long-term debt financing costs may eventually prompt a larger policy response in the form of more active Treasury debt management and/or Fed policy actions to restrain the term premium impact on unintended policy tightening.

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