After months of declines, the US government bond market is in the midst of a sharp rally fueled by the expected end of the Federal Reserve's current interest rate hiking cycle.
All US Treasury yields, which move opposite prices, have fallen since peaking in mid-October, while the S&P US Treasury Bond Index — a measure of the Treasury market's performance — has increased more than 3.6% since Oct. 19 after falling about 7.5% from early April.
The rally is a tenuous one, however, and fixed income strategists caution that it could easily reverse if a stubbornly hot domestic economy compels Fed officials to maintain relatively tight monetary policy.
"The recent drop in yields has been caused by speculation that inflationary pressures are over, and that rate cuts will need to come quickly next year," said Althea Spinozzi, a senior fixed income strategist with Saxo Bank. "However, that can always change — inflation might start to decrease more slowly, and central banks might push back on rate cut expectations. That situation is bearish for bonds."
Yields plunge
The yield on the benchmark 10-year Treasury bond has fallen 71 basis points after settling at 4.98% on Oct. 19, its highest yield since 2007. Since Oct. 19, the 5-year yield has fallen 73 bps, the 7-year 72 bps, and the 30-year 67 bps. The 2-year yield, which tends to most closely reflect shorter-term interest rate expectations, has fallen 50 basis points to 4.64%.
"What is happening right now in the bond market is the realization that the Fed can be done hiking rates," said Patrick Leary, managing director with Loop Capital Markets. "The market has come very far, very fast."
After months of remaining persistently high, inflation growth has begun to make noticeable progress toward the Fed's 2% goal. Personal consumption expenditures excluding volatile food and energy prices, the central bank's preferred inflation measure, grew by 3.46% from October 2022 to October 2023, down from annual growth of 5.33% a year earlier, the US Bureau of Economic Analysis reported Nov. 30.
Rate cuts looming?
In addition, Fed officials have begun to signal that rate hikes are over. While the central bank increased its federal funds rate by 525 bps since March 2022, it has not raised rates in three of its past four meetings and is not expected to raise rates at the December meeting.
On Nov. 28, Fed Governor Christopher Waller said that if inflation continues to decline in the coming months, the Fed will likely start cutting rates.
"There is no reason to say we will keep it really high," Waller said during an event at the American Enterprise Institute.
Waller said that the Fed would increase rates again if price pressures rise, which would likely cause another rise in bond yields.
"A move back toward 5% is not improbable for the [10-year bond yield], but it's more likely that we've morphed into a structural decline in market rates, and a steeper curve," said Padhraic Garvey, managing director and regional head of research, Americas with ING. "Most of the time a peak for the Fed correlates with a good time to get long, or at least to average in as rates rise."
Months before these cuts, which Garvey anticipates will begin in mid-2024, the 2-year yield will likely move significantly lower, potentially by 100 bps in a matter of days if Fed officials strongly signal that cuts are coming.
For now, if Fed hikes have indeed peaked, the 10-year and other yields will continue to move downward, but likely not as quickly as the 2-year, potentially ending inversion in a key part of the Treasury yield curve.
"Assuming the [difference between the 2- and 10-year yields] needs a 100 bps valuation when the Fed is done at 3%, that places fair value for the 10-year at around 4%," Garvey said. "But the lure of the rate-cutting cycle likely sees the 10-year yield overshoot to the downside, potentially getting down to 3.5%.