The US economy should head toward a soft landing despite recent resilient data. (UBS)

Federal Reserve Governor Christopher Waller, speaking at a virtual event on Tuesday, said the US central bank should take a cautious and systematic approach when it begins cutting interest rates, and that there is “no reason to move as quickly or cut as rapidly as in the past.” On the data front, US retail sales in December rose 0.6% month-over-month, higher than the market forecast for a 0.4% expansion and the biggest increase in three months. The CME FedWatch Tool now suggests a 63% chance of a March cut based on 30-day fed funds futures pricing, down from over 80% last week.

But while we have held the view that market expectations of a first rate cut in March look too optimistic, we believe the need for investors to manage liquidity and lock in yields remains pressing. We continue to hold quality bonds as most preferred in our global portfolios:

Rate cuts are firmly on the horizon, with yields to decline this year. While Waller said the timing of cuts will depend on the incoming data, he also indicated that the process of rate cuts can start this year absent a rebound in inflation. He added that he is becoming more confident that policymakers are “within striking distance” of reaching their 2% inflation target, and that it would also be reasonable for the Fed to start thinking about slowing the pace of asset runoff “some time this year.” Separately, there are more signs of a cooling labor market, with wage pressures expected to ease and wage growth looking likely to fall further, according to the Fed's Beige Book survey of regional business contacts published on Wednesday. We continue to expect 100 basis points of US rate cuts this year, most probably beginning in May. Our year-end forecast for the 10-year US Treasury yield stands at 3.5%.

The US economy should head toward a soft landing despite recent resilient data. We expect US economic growth to slow to just below trend this year in our base case. While job creation remains robust with a still-low unemployment rate and strong household balance sheets, we think mounting obstacles to growth—poor housing affordability, the end of childcare subsidies, and the trimming of Medicaid—point to slowing activity ahead. The latest data showed that while US industrial production rose a marginal 0.1% in December from the previous month, output for the fourth quarter was down 3.1% year-over-year.

Quality fixed income has an attractive risk-return proposition. We expect total returns for high-quality, medium-duration fixed income to be in the mid-single-digit range in our base case. In a hard-landing scenario, we would expect double-digit returns. Even in a "Goldilocks" scenario of more robust US growth, faster-than-expected falls in US inflation, and preemptive Fed rate cuts (the least favorable outcome for highly rated bonds), total returns are still likely to be positive.

So, while yield volatility is likely to remain elevated in the near term, high reinvestment risks for investors with elevated cash balances raise the appeal of putting money to work in quality bonds. We particularly like the 5-year duration segment as it offers an appealing combination of higher yields and greater stability than the longer end, as well as some sensitivity to falling interest rate expectations.

Main contributors - Solita Marcelli, Mark Haefele, Daisy Tseng, Jennifer Stahmer, Vincent Heaney, Matthew Carter

Original report - Bond outlook remains positive despite lower rate expectations, 18 January 2024.