Bond Market Momentum: A Closer Look at Q1 Markets
First Quarter, 2024
John R. Sides, CFA
As we approached the beginning of 2024, the market narrative around a “Fed pivot” was firmly in place. On January 1st, front-end interest rates were pricing in expectations of 150 basis points of rate cuts by the Federal Reserve in 2024. Expectations of significant easing would offer a definitive boon to equities, corporate credit, structured products, and government bonds. The Treasury yield curve was sure to steepen aggressively, giving bank balance sheets a boost and re-igniting a significant driver of demand for agency MBS. While an easing of financial conditions should lift all risk assets, the outlook for corporate credit was slightly more muddled as spreads began the year at historically tight levels.
As the quarter progressed, that narrative began to unwind. Inflation data stopped falling as dramatically as it did in the second half of 2023. The most recent reading of Core CPI (ex-Food & Energy) at 3.8% year-over-year is only 0.10% lower than the December 2023 reading. The most recent measure of Core PCE at 2.8% – the Fed’s preferred measure of inflation – while trending in the right direction, is still well above their 2.0% target. However, the outlook for above-trend growth and a resilient consumer remained intact. Consumer sentiment as measured by the University of Michigan Index reached the highest levels since 2021. All of this led to the market pricing in fewer rate cuts throughout the quarter as a “higher for longer” Fed policy became an increasing possibility. By the end of the quarter, only 75 basis points of rate cuts were implied by the market.
The markets adjusted, but the effect across asset classes was mixed. Government bond yields were range-bound in January but trended higher by quarter-end. By March 31st the 30-year Treasury yield was 31 basis points higher on a year-to-date basis while the 5-year yield was 37 basis points higher. During the quarter agency MBS saw modestly negative excess returns of -14 basis points, however, the relative value proposition versus corporates and Treasuries remains firmly in place. Investment-grade corporate credit overpowered both tight starting spreads and a historic deluge of new issuance to end the quarter with excess returns of +89 basis points. This was led by the higher beta corners of the market. The outlook for bond markets remains inextricably linked to inflation, growth, and the Fed’s ensuing policy response.
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