Investors Bank on Fed Capitulation, Sending Bond Yields Soaring

At this week's policy meeting, bond investors anticipate that the Federal Reserve will renounce its program of raising interest rates, preparing the market for the possibility of numerous rate cuts this year-the first since the COVID-19 epidemic began in 2020.

Portfolio managers have boosted their investments in long-term U.S. Treasuries before the meeting, indicating anticipations that as the U.S. central bank moves toward lowering rates, the returns on such assets will decrease. Longer-duration bonds often outperform other investments as the economy slows.

Bonds with extended maturities and lower coupon rates typically exhibit longer durations, making them more responsive to fluctuations in interest rates. Kathy Jones, Chief Fixed Income Strategist at the Schwab Center for Financial Research in New York, recommended extending duration in anticipation of a turning economic cycle over the past year.

Fed's Policy Meeting and Rate Outlook

At the conclusion of its two-day policy meeting on Wednesday, the Fed is mostly anticipated to keep interest rates unchanged. However, some investors see a chance for the Fed to shift to a more dovish stance after it was seen to have veered from a tightening policy outlook during its meeting last month.

At the December 12-13 meeting, 17 out of 19 Federal Reserve officials predicted a lower policy rate by the end of the current year compared to the previous month. The Fed's median projection indicated a decrease of three-quarters of a percentage point from the existing 5.25%-5.50% range.

Guneet Dhingra, Managing Director and Head of U.S. Rates Strategy at Morgan Stanley in New York, suggested the Fed might discuss an easing bias more prominently this week, raising questions about the speed and intensity of the potential easing.

Rate cut wagers were a touch more active in the rate futures market. LSEG's rate probability software indicates that five 25-basis-point cuts to the U.S. central bank's benchmark overnight interest rate are priced into federal funds futures, a simple indicator of where traders think it will be at any given time. This is true for 2024.

With a 91% chance, the market is pricing in the first rate decrease to happen at the meeting on April 30-May 1. Less than 50% of futures pointed to a reduction during the March 19-20 meeting. Three weeks ago, the odds of a reduction in March were as high as 80%.

Jeff Klingelhofer, Co-Head of Investments at Thornburg Investment Management in Santa Fe, New Mexico, managing around $43 billion in assets, stated, "We have shifted to longer duration for all the portfolios we manage."

He emphasized the reluctance to revert to higher rates, expressing the view that the bar for such a move is quite high. Klingelhofer noted the aggressive nature of the Federal Reserve's rate hikes in the last two years, suggesting a higher likelihood of a U.S. recession than a return to higher rates.

However, after the meeting last month, unexpectedly positive results for the fourth quarter of 2023's gross domestic product growth and December's non-farm payrolls in the United States have been reported.

According to Ryan Swift, a bond analyst at BCA Research in Montreal, investors would be better off reducing some of the inherent rate cuts in the futures contracts in the near term since federal funds futures are now too dovish despite a string of generally positive U.S. economic data. This supports maintaining a flat bias or keeping portfolio duration near the benchmark, he added.