As bonds emerge from a brutal three year selloff, where macroeconomics and interest rates dominated the outlook, investors expect better times in the U.S. fixed income market in 2024. Treasuries have rallied substantially in the last quarter of 2023 but are still likely to deliver good returns this year, despite yields pulling back from their peaks, as they still remain relatively high.

The impetus behind the gains stems from expectations that the Federal Reserve has likely finished its rate hiking campaign and is poised to start cutting borrowing costs in 2024. This sentiment has gained further traction when policymakers unexpectedly pencilled in 75 basis points of easing in their December economic projections amid signs that inflation continued to moderate.

The anticipated decline in interest rates is expected to drive Treasury yields lower and boost bond prices higher. Such scenario is foreseen by considerable number of investors, which are holding their biggest overweight position in bonds since 2009. Nevertheless, there are lingering concerns that the path to lower yields may be bumpy, as yields have dropped more than 100 basis point since last October, and has run ahead of the central bank rhetoric, leaving the market susceptible to abrupt short-term reversals.

While inflation in the U.S. is declining, it is still well above the Federal Reserve target, and we expect interest rates to remain elevated into the second half of the year. Given the current macro-economic backdrop, we are of the view that the Fed will remain on hold until inflation is close to 2% before it begins to ease in the face of slowing economic growth. Despite the recent rally in Treasuries, yields remain very compelling at current levels, with the U.S. 20-year Treasury now yielding 4.27%.

Meanwhile, the market appears to have priced in around 150 basis points in cuts in 2024, twice the figure policymakers have outlined. Opinions also diverge in regard to the likelihood of hard vs. a soft landing, as well as when the central bank will start cutting rates and not just by how much. Nonetheless, the Fed will start easing monetary policy as inflation declines back to target and the economy experience slower growth.

Source: TradingView

Overall, 2023 was a year of transition for the global economy. As inflation started moderating, attention turned to slowing economic growth and prospects for interest rate cuts in 2024. This resulted in a rollercoaster ride with the 20-year U.S. Treasury yields reaching a high of 5.51% at the end of October 2023 before retreating to 4.09% at the end of December 2023 and driving bond prices up.

Despite the strong run in the bond prices over the past two months, we are of the view that the rally has not run its course yet and we remain optimistic for 2024. While in the short-term the 20-year Treasury yields could rise to 4.50%, which we see as merely unwinding oversold momentum conditions, a subsequent decline to 3.75% – 3.80% over the medium-term is on the cards. Therefore, it is not too late to join the bonds rally, as today’s environment is favourable, offering attractive yield and capital appreciation potential.