Bonds: Is the Recovery Rally Over?

In a December 14 Barchart article, Bond Prices: How High Can They Rise, I wrote:

In late October, the U.S. 30-year Treasury Bond futures reached what was an unsustainable low at 107-04 before recovering to the latest high above 123. While the long-term trend remains lower, the bonds ran out of bearish steam and have moved into a short-term bullish trend. 

The U.S. long bond futures returned to above the 119 level on January 26. While the short-term trend has turned bearish, the odds of a return to the late October lows are low. 

Bond futures pull back

The bearish trend since the March 2020 high took the continuous U.S. 30-Year Treasury Bond futures contract to a 107-04 low in late October 2023, where it ran out of downside steam. 

As the chart highlights, the long bond futures rallied from the October low, reaching 125-30 in late December. Over the past weeks, the bonds pulled back below the 120 level and were at just under 121 on January 25. While the bonds have rallied from the October 2023 low, the longer-term trend since the 2020 high remains bearish, with technical resistance at 125-30 and 134-14, the April 2023 high.

Inflation has stabilized- December data was mixed

A significant reason for the bond rally was the trend in inflation data over the past months. The highest inflationary pressures since the 1980s caused the U.S. central bank to tighten credit, pushing the Fed Funds Rate from zero in March 2022 to 5.375%. Quantitative tightening to reduce the Fed’s swollen balance sheet moved rates higher further along the yield curve. 

With consumer and producer price indices stabilizing and falling during the final months of 2023, bonds rallied as tightening pressure declined. 

The December data showed CPI came in slightly hotter than expected, but PPI balanced the inflationary fears with a marginally lower-than-expected reading. The Fed’s favored December PCE indicator eased to 2.9%, the lowest since 2021. Therefore, bond prices stabilized in early 2024 at higher than the October low but lower than the late December peak. 

Do not expect much from the Fed in an election year

The U.S. central bank’s mission is stable prices and full employment, and while some people may disagree, the Fed attempts to be an apolitical body. The President nominates the Fed Chairman and governors, and the Senate approves the nominations. In 2024, the contentious election that seems likely to repeat the 2020 contest will likely cause the Fed to tread carefully to avoid any significant economic consequences that give the incumbent or challenger an advantage. 

Therefore, the markets should expect little from the Fed in 2024. While the late 2023 rally in bonds came price the rising expectations for lower interest rates in 2024, any rate cuts will likely be nominal, within 25-50 basis points. 

Markets have adjusted to the current rate environment

The U.S. stock market has risen to record territory, a testament to the market’s adjustment to the higher interest rate environment. While fixed-income assets caused some capital to flow from stocks to bonds in October 2023, pressing the leading indices, the decline in inflationary pressures caused stocks to come storming back on the upside. 

After the sticker shock caused by the rise in 30-year conventional mortgage rates that took them from below 3% in late 2021 to over 8% in October 2023, rates have fallen below the 7% level. We could see an increase in new home buying and building in the spring of 2024 as existing home sales remain tight, with homeowners holding under 4% mortgages not likely to sell. 

Rates were far too low following the 2020 global pandemic when the Fed Funds Rate fell to zero percent. The inflationary surge caused rates to rise quickly, but the recent decline has put interest rates at more tolerable levels in early 2024. 

Geopolitics will dictate inflationary pressures and the Fed’s response

While economics will dictate the path of least resistance of U.S. interest rates, the geopolitical landscape remains a clear and present danger in early 2024. Escalating tensions in the Middle East and the ongoing war in Ukraine could cause more than a few bouts of volatility in markets across all asset classes. 

Any surprises arising from the conflicts could alter the Fed’s policies. Moreover, the United States remains the world’s leading economy, with U.S. bonds being a haven for investors during economic turmoil. U.S. bonds remain in a bearish trend since the 2020 highs, but any surprises or shocks to the system could lift them for a challenge to the late 2023 highs or April 2023 peak that would end the bearish trend. 

Time will tell if the recovery in the U.S. bond market is over or if the rally has paused and we are in a consolidation period. Barring unforeseen events, the U.S. 2024 election, which will determine the path of U.S. domestic and foreign policy, will likely keep bond volatility low through November. 

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