With the Fed on hold, is the case for bonds kaput?

As inflation data has come in higher than expected recently, the number of Fed rate cuts expected by the market in 2024 has fallen from six at the beginning of the year to just one or two. By the end of April, the 10-year US Treasury yield had risen more than 80 bps year to date and the Bloomberg US Aggregate Bond Index had returned around -3%.

While the Fed decision to hold off on rate cuts for an extended period (it’s been nine months since the central bank stopped hiking rates) may be disappointing to the market, it does not necessarily scuttle the case for owning bonds. We saw a similar situation following the Fed tightening cycle of 2004 – 2006. The Fed hiked rates 17 times during that cycle (versus 11 in the current cycle) and then was “on hold” for 15 months before delivering the first rate cut in September 2007.

Despite the lengthy delay, bonds outperformed cash over the one-, two-, and three-year periods following the last hike in June of 2006 (Figure 1). For example, over the two years after the June 2006 rate hike, cash returned 9%, but government bonds returned 16%, the aggregate index 14%, and corporate bonds 11%. In Figure 2, we can see that yields bounced around in the year following the last rate hike of 2006 and then declined the following year as the Fed’s cutting cycle began (in September 2007), producing capital gains for bonds.

Figure 1

Figure 2

We would offer three takeaways for investors to consider:

• As long as the next move is expected to be a rate cut, markets should eventually anticipate this by driving yields lower and prices higher.
• When the wait for rate cuts is longer, the investment horizon may also need to lengthen to pursue meaningful outperformance versus cash.
• Even though economic growth has proven resilient recently, there are early signs it may be slowing, including in employment and service sector data (in April, the services Purchasing Managers’ Index fell below 50 for the first time since December 2022), which could prompt the Fed to ease this year.

There are risks, of course. Not long after the 2004 – 2006 tightening cycle and the rate cuts that followed, we saw the global financial crisis emerge and corporate bond spreads blow out due to liquidity strains in the financial system. Today, while not impossible, it is difficult to envision rate cuts against a backdrop of a severe recession, given that economic growth and employment are solid and there are few excesses in corporate or consumer balance sheets. We think the more likely risk is the potential for the Fed to pivot back to rate hikes if inflation remains stubbornly above its 2% target. But in his May 1 press conference, Fed Chair Jerome Powell said the Federal Open Market Committee’s working assumption is that the next move will still be a cut given restrictive policy and signs of labor market softening. He did say that it will take longer than expected to get to rate cuts, as policy tightening and other post-pandemic adjustments are working their way through the economy with a lag. But he was also more explicit about possible paths to a rate cut than a rate hike.

Investment implications

• We think investors should still consider moving out of cash and into bonds. The Fed being on hold for a long stretch is not unprecedented. Even with the Fed on hold for 15 months after the 2004 – 2006 tightening cycle, bonds outperformed cash over multiple time periods.
• The Fed’s next move still seems more likely to be a rate cut than a hike. While the Fed is far from all knowing, it has pointed to softer labor data and signs of continued post-pandemic normalization.
• Yields appear to be fair. The market is pricing in about one or two rate cuts by year end, a much more reasonable expectation than the six rate cuts priced at the beginning of the year.