US bonds are on track to record their best monthly performance in nearly four decades, as growing optimism about interest rate cuts by the Federal Reserve next year fuels a dramatic rebound from an early autumn sell-off.
The Bloomberg US Aggregate Bond index, a widely tracked measure of total returns on US fixed income, has risen 4.3 per cent so far in November, putting it on course for its best monthly showing since 1985.
The rally has nudged the benchmark’s total returns this year into positive territory, raising hopes it can avoid notching up a three-year string of losses — an unprecedented event in its 47 years.
Bond prices have surged and yields dropped this month as traders have increased their bets that the Fed has finished raising interest rates.
Prices of government debt around the world have followed the US higher, leaving the Bloomberg Global Aggregate Bond index on course for its best month since the financial crisis in 2008.
Interest rate futures indicate investors have swung to fully pricing in a quarter-point cut by the Fed’s May meeting, compared with expectations in mid-October that there was no chance of a cut by mid-2024.
“If you’d polled 1,000 portfolio managers six weeks ago, I doubt any would’ve said we’d be at these levels now, but there’s a lot of fast money that can move on just one or two events,” said John Kerschner, portfolio manager at Janus Henderson.
The rally has also pushed down yields on 10-year Treasuries from a 16-year peak of 5.02 per cent a month ago to a low of 4.25 per cent on Wednesday. That is below levels on September 20, when the Fed last published its quarterly economic projections. These contained a higher-for-longer message that drove yields towards their peak.
Bullish investors were encouraged on Tuesday from one of the Fed’s most hawkish policymakers, Christopher Waller, said he was “increasingly confident” that the Fed’s current policy was “well positioned” to bring inflation back to the Fed’s target of 2 per cent.
“It’s not obvious this was Waller’s intention, but coming from a hawk, the comments have a lot of influence. It definitely opens the door to a first-half rate cut,” said Alan Ruskin, chief international strategist at Deutsche Bank in New York.
Also bolstering sentiment was a revision of GDP data on Wednesday, which showed that inflation was slower than previously thought in the third quarter. The PCE price index — the Fed’s preferred measure of inflation — was revised downward by 0.1 percentage point to 2.8 per cent.
Treasuries make up the biggest group in the Aggregate index. While 10-year yields are still higher than where they started the year, the recovery in recent weeks has been striking and has allowed for a recovery in other parts of the bond market.
“I think this rally is real. If I were betting, I would expect yields to be lower than they are today by year-end,” said Blake Gwinn, US rates strategist at NatWest Markets. “If inflation comes down as we expect, it gives the Fed the latitude to cut. This is why we’re starting to talk about cuts. Now the Fed can be more reactive to risks on the growth side of their mandate.”
Investment-grade corporate bonds, which make up about a quarter of the Aggregate index, have also staged a powerful recovery in November. The average premium — or spread — paid by high-grade issuers to borrow compared with the US Treasury narrowed to just 1.14 percentage points this week — the tightest level since February 2022.
Corporate bond funds, including those tracking riskier junk-rated borrowers, have pulled in more than $17bn of cash so far in November, paving the way for the biggest monthly net inflows since July 2022.
“The driver of those inflows has been the decline in rates volatility and [investors’] realisation that ‘I now have the best yield support I have had in probably 16 years and the forward outlook for monetary policy has become a lot more predictable and a lot more benign’,” said Lotfi Karoui, chief credit strategist at Goldman Sachs.
“We went from an environment where there was a wide range of outcomes as far as the path of Fed funds go, to an environment where really the only question is with respect to the timing and the magnitude of the cuts,” he added.
The fall in yields has also coincided with a shift in the US Treasury’s borrowing plans. Having warned in August that they would meaningfully increase the size of bond auctions to cover tax shortfalls, officials in late October said they would slow the pace of its borrowing, taking some of the pressure off prices.
Not all market participants are convinced, however, that this is necessarily the turning point that recent moves suggest it is.
“I think it’s gone too far, and we’ll see a small pullback by year-end,” said Janus Henderson’s Kerschner. “Perhaps Powell talks the market down after the Fed meeting.”
The central bank’s last meeting for 2023 concludes on December 13. While investors are not expecting a change in interest rates, they will play close attention to the Fed’s updated economic projections.
