Bond Market Outlook: Why U.S. Treasuries Look Expensive Ahead of the Upcoming Rate-Cutting Cycle Bond Market Outlook: Why U.S. Treasuries Look Expensive Ahead of the Upcoming Rate-Cutting Cycle Bond Market Outlook: Why U.S. Treasuries Look Expensive Ahead of the Upcoming Rate-Cutting Cycle

Bond Market Outlook: Why U.S. Treasuries Look Expensive Ahead of the Upcoming Rate-Cutting Cycle

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:

  • Inflation Expectations Drive the Rally: Falling breakeven rates, triggered by lower oil prices and economic weakness, suggest markets are pricing in inflation below the Fed’s 2% target, driving the bond rally.
  • Limited Room for Further Gains: 10-year Treasury yields have already dropped significantly, reducing the potential for further declines, especially if a recession doesn’t materialize.
  • Underpriced Inflation Risk: The market is underestimating the potential for inflation to rebound, which could lead to rising yields and declining bond prices if inflationary pressures return.

Introduction

The recent rally in U.S. Treasury (UST) bonds has raised questions about the sustainability of current pricing levels. Historically, bond yields tend to decline heading into an easing cycle, driven primarily by lower real yields and wider breakeven rates, as the Federal Reserve cuts rates to stimulate the economy.

However, this time, we are seeing an unusual pattern. Despite expectations of a prolonged and aggressive easing cycle, breakeven rates have fallen faster than real rates, signaling that markets are pricing inflation to fall below the Fed’s 2% target. This is surprising because, typically, Fed rate cuts would lead to higher long-term breakeven inflation rates, as monetary easing stimulates the economy.

The disconnect between falling breakeven rates (signaling lower inflation expectations) and more resilient real yields (indicating tighter policy) reflects the uncertainty in the current market environment. Markets are anticipating lower inflation due to slowing economic activity, but the higher real yields suggest that, for the Fed to meaningfully shift policy, it may need to cut rates more aggressively than currently expected. Elevated real yields are also a sign that investors are hedging against persistent economic headwinds rather than a complete breakdown in economic fundamentals.

What Is Driving the Recent Rally in US Treasuries?

The recent rally in Treasuries, particularly the decline in 10-year yields, has been driven by expectations of economic weakness. Several key factors have contributed to this:

  1. Oil Prices and Inflation Expectations:
    A key trigger for the bond rally has been the decline in crude oil prices. Oil falling below $70 per barrel, its lowest level since December 2021, has heightened fears that inflation may undershoot the Fed’s target. This drop in inflation expectations has led investors to move into Treasuries, pushing yields lower. The 10-year breakeven inflation rate, which measures expected inflation over the next decade, has fallen to 2.02% — the lowest since 2021. Even more telling, breakeven rates for shorter-term bonds (up to 5 years) have fallen below the Fed’s 2% target. This indicates that investors are now pricing in the possibility of inflation undershooting over the medium term, reinforcing expectations of an aggressive rate-cutting cycle by the Fed.
  2. Breakeven Rates and Real Yields:
    Interestingly, the decline in yields has been primarily driven by falling breakeven rates, rather than real yields. While breakeven rates have dropped significantly, real yields (which are tied to inflation-protected securities or TIPS) have only fallen to levels last seen in July of last year. This disconnect highlights that inflation expectations are driving the rally, rather than a significant deterioration in real economic conditions. Elevated real yields reflect a restrictive policy environment, meaning that for the Federal Reserve to become less restrictive, it may need to cut rates more aggressively than markets currently expect.
Source: Bloomberg.

Why Treasuries Appear Overvalued?

1. Limited Room for Further Yield Declines:

Treasury prices have already recovered more than 50% from their post-2020 declines, significantly reducing the upside potential even if a recession materializes. Historically, bond yields have fallen by around 200 basis points (bps) during recessions. Since their recent peak in October 2023, 10-year Treasury yields have already dropped by 140 bps. With this substantial decline already priced in, the potential for further yield declines appears limited. Moreover, inflation remains elevated, and the timeline for any potential recession is uncertain. The market may find it difficult to price the Fed funds rate below 3%, which Philadelphia Fed President Patrick Harker recently suggested as the new long-term neutral rate.

2. Declining Convexity Appeal:

Bonds tend to perform well during recessions due to their positive convexity, meaning prices rise more as yields fall. However, with 10-year yields already down 130 bps from their highs, the positive convexity of bonds is losing its appeal. Historically, the peak-to-trough decline in yields during a recession averages about 200 bps. With yields having already fallen significantly, further price appreciation seems unlikely unless a severe recession materializes, which current economic data does not strongly support.

3. Recession Risk Overstated:

While the bond market appears to be pricing in a recession, the economic data suggests otherwise. Tight credit spreads, historically high profit margins, and declining bankruptcy filings indicate that businesses are not under significant financial stress. Additionally, low unemployment claims suggest that the labor market remains resilient, making the case for an imminent recession less convincing. If a recession does not occur, the current pricing of Treasuries could prove too rich, leaving investors with limited upside.

4. Underpricing of Inflation Risks:

The market is currently underpricing the risk of inflation returning. Several factors, including rising food prices and easier access to credit, could lead to a resurgence in inflation. The St. Louis Fed's Price Pressures Index is already signaling a near 100% probability that headline PCE (Personal Consumption Expenditures) inflation will exceed 2.5% over the next year. If inflation picks up again, bond yields could rise, which would hurt Treasury prices. Given the market’s current focus on downside risks, the possibility of a return to inflationary pressures seems to be underappreciated.

Preserving Capital: Why Savvy Investors Are Opting for Cash and T-Bills at 5%

Savvy investors like Warren Buffett have recognized that, at this stage, there is little to gain from extending duration in Treasuries or heavily investing in the stock market. Buffett himself has chosen to hold onto cash, acknowledging the lack of attractive opportunities in the current environment. For investors looking for a secure place to park their money while waiting for more favorable conditions, U.S. Treasury bills (T-bills) offer a compelling option, yielding around 5%. These short-term instruments provide a solid return without exposing investors to the risks associated with longer-duration bonds or volatile equity markets.

Given the uncertain economic outlook and the limited upside in Treasuries, it may be wise to take advantage of the attractive yields in T-bills. This allows investors to preserve capital and earn a respectable return while keeping liquidity high, positioning themselves to move into better opportunities when the market outlook improves.

If you'd like to learn more about T-bills and how they can fit into your investment strategy, you can refer to this page.

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