Fed forecasts are not set in stone, and they expect falling inflation and job growth to lead to a more dovish outcome. (UBS)

A 1.6% fall in the index on Thursday was the worst daily slump since March and took the index to the lowest level in three months.

At the Fed's meeting, policymakers dented hopes of brisk rate-cutting in 2024, with the "dot plot" of official expectations halving the predicted pace of easing to 50 basis points for the year compared to the prior forecast. Concerns that rates could remain higher for longer, which were intensified by a fall in unemployment claims, pushed up the yield on the 10-year US Treasury to its highest level since 2007 at 4.49%. The yield on the 2-year rose to the highest level since 2006 at 5.2% on an intraday basis.

However, in our view, Fed forecasts are not set in stone, and we expect falling inflation and job growth to lead to a more dovish outcome. Other top central banks on Wednesday added to our conviction that an end to the global hiking cycle is close at hand. Both the Bank of England and the Swiss National Bank surprised markets by refraining from rate hikes. And while the European Central Bank raised rates this month, it clearly signaled further tightening was unlikely to be needed.

An imminent end to hikes worldwide would support our preference for fixed income, and we remain most preferred on quality bonds for a variety of other reasons.

High-quality bonds should outperform cash in most Fed rate scenarios over 6–12 months. Today’s high bond yields offer an attractive opportunity to lock in rates, in our view. We also think that bonds can outperform cash in most plausible Fed interest rate scenarios over the next 12 months. Even in scenarios where the Fed hikes interest rates to a 5.5% or 6% ceiling, holds for several months, and then is forced to cut rates to 2.5% to tackle a recession, we estimate 10-year US Treasuries would offer total returns in the region of 10–15%.

We think any mark-to-market losses on high-quality bonds would be limited. If we stress test what it would take for an investor in 5-year US Treasuries to suffer mark-to-market losses on their investment, we must assume that the bond’s yield rises by more than 105 basis points from the present 4.6% level. We think this is unlikely given our expectation that US growth and inflation will moderate through year-end and into early 2024.

Long-term investors with below-target allocations can rebuild to balance portfolios. Many investors sold high-quality bonds in the post-financial-crisis period of ultra-low interest rates. However, we think high-quality debt has an important role in portfolios as both a source of returns and long-term diversifier. Based on our capital market assumptions, we expect bonds in general to offer between 15% and 25% total returns over the next five years, depending on currency and credit quality.

Historical data is also supportive. US government bonds have outperformed USD cash in 83% of five-year periods since 1925. If we look at all five-year periods since January 1977 (the earliest point with available data on a higher 2-year than 10-year Treasury yield, known as curve inversion), US government bonds have outperformed in about 90% of the time, and in 97% of five-year periods when the yield curve was inverted at the beginning of the five-year period.

Last, investors wary of bonds’ diversification power should remember that the simultaneous annual losses for US stocks and bonds—like in 2022—have occurred only three times since 1926. In our scenario analysis, we think that 10-year US Treasury bonds could rally by 21% in a downside scenario where global equities decline 17%.

For those reluctant to over-rely on high-quality debt, we note that alternative investments helped diversify returns last year, with alternative indexes yielding between –6% and +17% depending on the strategy deployed.

Main contributors - Solita Marcelli, Mark Haefele, Paul Donovan, Christopher Swann, Vincent Heaney, Jon Gordon, Brian Rose

Original report - Nearing end to global hiking cycle bodes well for bonds, 22 September 2023.