Perspectives

A stronger-than-expected economy renewed the market’s concerns about persistent inflation, driving fourth quarter bond market returns well into negative territory. The market found its direction from a strong labor market, resilient consumer, and the Fed’s hawkish surprise. A brief bout of volatility following the Republican sweep in the November elections did little to deter rates from moving higher. While the Fed delivered two widely anticipated 25 basis-point cuts, the Committee provided an unexpected shift in forward guidance. Highlighting projections for faster growth in 2025 and slower progress toward the 2% target inflation level, the Committee signaled a shallower easing cycle and a higher-for-longer rate environment. Guidance included two fewer cuts in 2025 than anticipated in September and a 25 basis-point increase to the longer-term fed funds rate.

The Bloomberg Aggregate Bond Index dropped -3.1% for the fourth quarter, giving back most of its strong third-quarter gains and reducing its full-year return to 1.3%. In what is typically a strong period, the market stumbled to its worst fourth quarter in decades. A series of strong economic data releases, starting with employment data in early October, drove most of the curve steeper. The 2-year and 10-year Treasury yields rose sharply, climbing 70 and 96 basis points, respectively, from their year-to-date lows in September. This steepening pushed the 2s-to-10s yield curve farther into positive territory, while the 3 month-to-10s yield curve steepened by 110 basis points, entering positive territory for the first time in over two years.

Corporate credit markets reflected a benign outlook for risk with spreads tightening further and lower-rated securities outperforming in both investment grade and high yield segments. Bolstered by a resilient economy and yield-driven demand, investment grade spreads tightened through their post-GFC tights. Although spreads eased slightly by the end the quarter, finishing nine basis points tighter, they briefly reached levels not seen since the late 1990s. The high yield sector narrowly posted a positive return, with higher yields and shorter duration mitigating the impact of curve steepening. The corporate sector continued to benefit from favorable market dynamics as investor demand for attractive all-in yields fully absorbed a heavier-than-expected issuance calendar. Fundamentals also remained supportive, with economic conditions and corporate financial policies buoying earnings and credit measures.

Within securitized, Agency MBS slightly underperformed other high-quality sectors due to large swings in rate volatility during the quarter. Mortgage rates retraced higher, lowering refinance activity and providing a favorable carry environment for premium mortgage pools. Low refinance activity and slow seasonal housing turnover led to benign supply, offering a tailwind to the sector. Spreads remain attractive relative to historical levels and the sector should benefit from a positive technical environment next year. Asset-backed securities were a standout within both securitized and the broader Index, driven by strong demand for front-end securities with the steepening yield curve. The sector remains an attractive source of income.

Heading into 2025, the combination of a remarkably resilient US economy, stalled progress on inflation and the potential for inflationary measures from the new administration has the market fretting about the direction of monetary policy. Heightened sensitivity to the inflation outlook, coupled with the Fed’s recent guidance shift, has sent longer-term rates back toward their 2024 highs.

The aggressive backup in yields and the significant recalibration of Fed policy is now fully discounted in the market, leading us to believe we may have seen the peak in rates. The Fed’s reaction function remains skewed toward an easing path as inflation normalizes. The magnitude and direction of the impact of Trump’s policies on inflation won’t be understood for quite some time, and not fully until at least 2026. This backdrop should help anchor the short-to-intermediate part of the yield curve, while investor appetite for absolute yield should continue to limit further weakness in longer maturities.

The ongoing strength of the US economy, alongside gradually moderating inflation and some of the highest yields seen in the bond market post-GFC, offers a compelling setup for risk assets to be emphasized for the positive carry.

With contributions from members of our Taxable Bond Team