The Destination, Not the Journey

Interest rate expectations are volatile right now, but focus on the fact that almost everyone agrees rates have peaked and their next move is down.

The highest-rated core government bonds are called “risk free” not because their prices don’t go up and down, sometimes wildly, and not because they are insensitive to shifting economic forces. It’s because it’s as certain as anything can be in financial markets that investors will be paid the same coupon every six months and get all their money back at maturity.

We think focusing on that end point rather than on the path—the destination, not the journey—is important for fixed income investors right now for two reasons.

First, it makes it easier to discern relative value on an inverted but gradually normalizing yield curve; and second, it could help with strategic thinking as we head into a year of potentially volatile interest rate expectations.

Curve

On today’s U.S. dollar yield curve, cash offers close to 5.5% while the two-year yield to maturity is just 4.3% and the five-year offers 3.9%. Some European curves are even more inverted.

So, it makes sense to sit on cash rather than take interest rate risk, right? Not if you focus on the end point rather than the journey. At the end of 2025, you will almost certainly still be receiving a two-year bond coupon worth around 4% of your principal investment. If you’re still holding cash, forward-rate markets suggest you’ll be getting just 3.4%.

In addition, by the end point of the journey, the yield of today’s two-year bond will have converged upon the interest rate for cash. If short-term rates do decline from here, that would lead to a “roll-down” yield adjustment on the bond—which translates into price appreciation on top of the coupon income.

Taken together, that means that while the cash rate comfortably beats the bond yield today, the estimated annualized total return of holding the two-year bond to maturity beats holding cash for two years.

Mismatch

In a nutshell, the overwhelming probability is that short-term interest rates have peaked and are on their way down sometime during 2024 and 2025. And that brings us to our second point about interest-rate volatility dynamics.

Rate expectations have been volatile since the U.S. Federal Reserve’s December meeting.

Investors initially responded to the central bank’s perceived dovish turn. More recently they have begun to digest policymakers’ persistently cautious commentary, as well as the ongoing strength in much U.S. economic data, including last Thursday’s slightly hotter-than-expected inflation numbers. Even so, market pricing remains well ahead of Fed projections: A rate cut is still priced for March, and almost twice as many cuts are priced for 2024 than are suggested in the policymakers’ own “dot plot.”

That mismatch could be one source of ongoing volatility.

Another is the likelihood that the Fed’s first rate cut will come before inflation has returned to 2%. How will investors interpret that? The move, three years ago, to a long-term average inflation target as opposed to a point-in-time target, could be used to justify anticipatory rate cuts. On the other hand, the structural policy goal of returning to the more “normal,” moderately positive real rates of the pre-Global Financial Crisis era would inform against anticipatory cuts.

Add the data-dependency of current monetary policy, and it is easy to imagine that the path of rate expectations through 2024 could be bumpy, indeed.

Stance

Again, however, we urge investors to focus on the end point rather than the path.

Central bank officials sound cautious about early rate cuts and about how loose policy might be in a year’s time—but they all acknowledge that the tightening of the past two years is having its desired effect. The Fed’s forecast that U.S. growth and inflation will be lower by the end of 2024 is in line with the consensus view of independent economists.

Fed policymakers may not expect to make six rate cuts this year, but they do anticipate three.

With that in mind, we think it becomes easier for fixed income investors to discern how the appropriate stance with regard to interest rate volatility has changed—particularly when it comes to points on the curve out to five years.

A year ago, it was sensible to have a bias toward being underweight duration, while watching for tactical opportunities to go longer should the market become over-pessimistic about inflation. Today, we think an overweight bias is more appropriate, while going tactically shorter when the market appears over-optimistic about rate cuts or government debt sustainability—as we believe it did during December.

By keeping eyes on the destination, not the journey, we think investors can draw a clearer distinction between their strategic price and yield targets and their yield points for tactical adjustments. In doing so, we are more likely to make the volatility of interest rate expectations a source of potential return, rather than just noise.