Lately, clients have been asking us one question: how are longer-term bond yields moving higher when the Federal Reserve is cutting interest rates? To answer this question, we first need to understand why the Fed is cutting rates. Essentially, changes in short-term interest rates are made in response to the Fed's desire to either slow the economy by raising interest rates or stimulate the economy by lowering them. Over the last year, the Fed has been cutting rates aggressively, with the most recent cut occurring in December. Clients will notice that the money market funds that were paying about 5% last year are only paying closer to 4% this year with the 1% decline (sum of rate cuts from 2024) in the Fed Funds rate.
Longer-term bond yields are set by buyers and sellers in the bond market. Since September 2024, the ten-year treasury, which is a good proxy for the long-term part of the bond market, is up about 1% in yield. This can be difficult to understand given what the Federal Reserve has done. Bond investors are demanding more yield for bonds due in large part to the uncertainty around the economic policies of the incoming Trump administration.
The president-elect has held discussions around massive increases in tariffs on imported goods. Despite the threat of high tariffs, we expect that many of the proposed tariffs are a negotiating tactic and in reality, will be much lower. Tariffs can be inflationary and that is in part what the bond market is reacting to. Additionally, there has been mention of tax cuts, which adds to the budget deficit and increases the need for the treasury to borrow more from investors.
Also putting pressure on bond yields to move higher is inflation, which has been sticky and slow to come down to the Fed's goal of 2%. The economy has been stronger than expected and the Federal Reserve has signaled that it will slow down on cutting short-term interest rates.
Our view is that we are close to the top of interest rates for this cycle. We have steadily brought our bond allocation up to a neutral weight from the minimum allocation we held five years ago. Bond yields are at the highest levels that we have seen in 15 years, and we think bonds are attractive not only for the generation of income but also for downside protection when we hit the inevitable correction of the stock market.
Takeaways for the Week
Bonds yields are the highest in 15 years and attractive from an income as well as protection from declines in the stock market.
The employment data from December came out on Friday and was significantly higher than expected and the unemployment rate ticked down to 4.1%. This shows strength in the economy which leads to an upward trend in long interest rates.