Rate cuts are on the agenda and bond yields are near post-pandemic highs. Now could be the time to take advantage of a potential golden age for fixed income.
Rates are at their peak, and rate cuts are set to follow
History may not repeat itself, but it usually rhymes. Nothing in the investment world demonstrates this better than economic and interest rate cycles.
Every few years, central banks typically raise rates to contain an overheating economy and then cut them to arrest slowing or receding growth. The impact on fixed income tends to be predictable: painful when rates rise, but beneficial when they fall.
It should therefore be no surprise that the last five rate cutting periods were golden ages for bond markets. The Bloomberg US Aggregate Bond Index (known as “the Agg”) returned between 16.6% and 31.5% two years following each of the cycle’s final rate hike (Figure 1).
Figure 1: Investors may still be able to make the most of a potential fixed income golden age[1]
The sweetspot for a fixed income allocation has generally been before the first rate cut – which we expect to see in the second half of 2024.
Importantly, the Agg has only returned 1.3% since the Fed’s last rate hike in July (over nine months ago), and US credit markets only 3.3%. In other words, we think investors still have time to “get in on the ground floor” of the potential upcoming golden age by allocating to fixed income now.
Bond yields are still close to post-pandemic highs, and often imply “equity like” returns
Even with rate cuts on the agenda, bond yields are still close to their recent highs. In some sectors, yields even imply buy-and-hold returns close to long-term equity total returns (Figure 2).
Figure 2: Yields remain elevated among multiple fixed income sector1
This situation may not persist, particularly once markets see rate cuts as imminent, so investors may benefit the most from acting quickly.
In our view, this environment lends itself to a multi-sector approach. Managers with specialist capabilities and credit analyst resources will likely be able to target a diverse portfolio that maximizes risk adjusted yields across these sectors and capitalize on relative value opportunities across each market.
A global approach may be the most comprehensive way to participate in the golden age
Casting the net wider to global fixed income markets may also be worth considering, particularly for those concerned about US rates remaining “higher for longer”.
The US economy appears to be materially outperforming its global peers, with the IMF even projecting the US will grow at double the pace of any of its G7 peers this year.
This might be good news for US risk assets relative to the rest of the world, but maybe not for US bonds, as it reflects more stubborn inflation in the US. As recently as last fall, CPI was running lower in the US than in Canada, the eurozone, the UK, Australia and New Zealand. But now, it’s running faster than all of them.
At the start of the year, many expected the US to be the first to cut rates among its peers, now it looks like it could be the last.
Those with a global approach may benefit from developed market rate cuts sooner than domestically constrained investors. Further, they are already benefiting from rate cuts in emerging markets, particularly LATAM, Asia and Central and Eastern Europe (Figure 3).
Figure 3: Emerging market countries are already cutting rates, the US could be one of the last to join in[2]
Don’t miss the fixed income golden age
Rate cutting cycles have only tended to happen every few years. We think this is a golden opportunity for investors to position themselves to fully take advantage of the next one.
Brendan Murphy is Head of Fixed Income, North America at Insight Investment, an investment firm of BNY Mellon Investment Management.
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[1] Bloomberg, Insight calculations, May 2024. Past performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
[2] Macrobond, National Sources, May 2024
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