Q4 Bond Market Outlook for ETF Investors
With markets anticipating the Federal Reserve to cut interest rates 150 basis points between now and mid-2025, position for a steepening yield curve with active short-term strategies, high yield, and mortgage-backed securities.
Don’t Fight the Fed
With the Federal Reserve (Fed) expected to cut interest rates multiple times over the next few meetings, investors should begin repositioning bond portfolios to follow the Fed. That means moving out of cash-like vehicles with declining yield and return potential and investing that capital in:
- Active short-term ETFs where managers have wider remits to position for increased yield and total return
- High income sectors where credit trends support risk-taking
- Mortgage-backed securities (MBS) or MBS-biased core strategies where declining rates are a tailwind and active managers can seek to exploit mispricings
Lower Rates, Steeper Curves, and Greater Growth
The market expects close to 75 basis points (bps) of additional cuts by year end and another 75 bps by the May 2025 meeting.1 The Fed’s dot plot offers a similar view, indicating a fedfunds rate below 4.50% by year end and below 3.5% by the end of 2025.2 While the projections differ, the consistent directional trend indicates that investors should prepare portfolios for lower rates.
Of course, the Fed is not alone in rate cuts. Market implied forecasts for central bank rates are lower in Europe, the UK, Sweden, Switzerland, Australia, New Zealand, Norway, and India through early 2025.3 Only in Japan are central bank rates not expected to decline further from the currently low 0.25%.4
Lower rates across the globe should stimulate forward looking growth expectations. Boosting already sturdy growth, as global GDP is still expected to be above 3% in 2024 and 2025, based on the median consensus economists’ forecasts.5
For the US, if growth matches the Atlanta Fed’s GDPNow forecast of 3% in Q36 and inflation continues to trend above 2%, yield curves should steepen. In fact, many portions of the yield curve already have un-inverted as the market has adapted to the re-normalization of global central bank policy. Five rate spread pairs (30-year minus 3-year, 10-year minus 3-year, 5-year minus 3-year, 30-year minus 2-year, and 10-year minus 2-year) now have a positive slope. And a sixth pair (5-year minus 2-year) is a tick away from joining them.
The un-inversion of these points on the yield curve has typically been positive for risk assets. Based on data since 1977, when all six of those yield curve differentials flip positive, the subsequent six-month return for equities is 5.44%.7 And if we use the trigger of a sustained flip (not just the first day), the return is a still-strong 4.92%.8 There is a positive skew as well, as there are more positive return periods than negative. This strengthens the case to allocate to credit.
Credit Trends Support Reaching for Yield
While today’s credit spreads remain tight, which may indicate credit is priced for perfection, five tailwinds underpin the case for credit:
A healthy labor market, resilient household demand, and business investment fueled a 2.9% real rise in final sales to private domestic purchasers. This key gauge of underlying demand has been above 2% for six consecutive quarters and above the 20-year historical average of 2.4% for four straight quarters.9
Corporate profits are poised to record their fifth consecutive quarter of growth.10 Double-digit earnings growth is expected for Q4 2024 as well, rounding out full-year 2024 growth at potentially 10% with 15% expected in 2025.
After downgrades outpaced upgrades in 2023, upgrades are outpacing downgrades in 2024 across a combined universe of investment-grade and high yield credit. And the global high yield default rate is 1.90%, well below the long-term average 3.75%.
Positive ratings momentum and fewer defaults indicate more balance within credit fundamentals, a trend also reflected in above average interest coverage ratios for high yield (both broad and high yield ex-energy).11
High yield issuers have brought $238 billion of new issuance to the market in just nine months, more than full-year issuance in 2022 and 2023.12 That trend holds for loans and investment-grade — indicating firms are seizing on strong investor demand for the carry associated with credit.13
High yield bonds yield around 7%, while senior loans have a yield around 9%.14 And even considering falling central bank rates, the yields for these below investment-grade markets tend not to fall in unison (Figure 1).
High yield has a 0.46 beta to the fedfunds rate, while floating rate senior loans have a slightly higher beta of 0.62, as credit spread trends counterbalance movements in rates — unlike with investment-grade floating rate notes where the beta is almost 1.
Solutions That Follow the Fed
Money market funds now hold $6.3 trillion.15 And given their relationship to the fedfunds rate, return expectations on that pile of cash should be lowered. As measured by US 3-month T-bills, a proxy for cash money market securities, those yields have moved in lockstep with the fedfunds rate, evidenced by a 98% correlation since 1971.16 That opens the door for investors to consider:
Short-term Active Core Strategies
Moving slightly up the curve from ultra-short money market exposures into the 1-3 year duration band still provides stability. Like ultra-short T-Bills, 1-3 year US Treasurys have a negative correlation to equities and credit.17
An actively managed short-duration strategy may be able to enhance income and total return potential, given that the wider opportunity set can include securitized credits. A yield for a portfolio of 1-3 year US Treasurys can be enhanced by adding under 3-year duration investment-grade credit, high yield credit, and MBS while still retaining a low rate risk profile (Figure 2).
Implementation Idea
High Income Strategies
As rates fall, the income potential from the traditional 60/40 portfolio will likely mean revert to its long-term trend (Figure 3).
Figure 3: 60/40 Portfolio's Yield Over Time
Against this backdrop, investors should seek out high income exposures like high yield bonds, senior loans, and preferred securities — particularly, given the conducive environment to take on credit risk.
Those three bond sectors still offer yields north of 5.5% (Figure 4), and that healthy coupon may lead to enhanced demand — a potential benefit from a total return perspective that helps justify the tight credit spread environment. And the preferred securities market is still primarily rated investment-grade.18
Implementation Ideas
Mortgages and Mortgage-biased Core Active Strategies
Mortgages may also see tailwinds. Entering Q4, mortgage duration sits in the historical 91st percentile (Figure 5). With the anticipation of lower central bank rates, and lower rates in general, 30-year fixed mortgage rates have declined and are trading around two-year lows.19
Analysts project that mortgage rates falling below 6% could spur a refinancing wave.20 And that could help bring duration in, leading to duration induced price appreciation given how anomalously extended duration is right now. This trend has been slowly developing already, as MBS has outperformed the Agg and US Treasurys by 0.3% and 0.7% over the past three months, coinciding with looser central bank policy.21
These trends in the housing and mortgage market also could lead to dislocations between newly issued MBS and older issues. With this backdrop, alongside the growth dynamics supportive of credit risks, intermediate core-plus managers with a mortgage bias, to both agency MBS, non-agency MBS, and CMBS could offer enhanced income and total return potential over traditional core indexes.