The Fed sent a message; what it means for bonds

The Federal Reserve’s decision to raise its overnight rate by 25 basis points at its September meeting fulfilled market expectations after last week’s hotter-than-expected inflation report.

The Federal Open Market Committee signaled another rate hike for this year but did not pencil one in for 2027, which is in line with current Vanguard forecasts. The decision comes after Consumer Price Index core inflation, not including food and energy, rose by 2.4% over the previous 12 months as of the end of August, while the Fed’s preferred measurements are running higher.

“Inflation is too high and has been for too long,” the Fed chair said in his press conference after the decision.

Fixed income investors now face the following:

• Intermediate-term bonds offer attractive yields. The intermediate-term part of the yield curve is near cycle highs, and the advantage that it offers over money market rates has widened to the most attractive levels in four years. Treasury yields between 2 and 10 years in maturity rose in the immediate aftermath of the Fed decision.
• Inflation remains higher but is contained. The Core Personal Consumption Expenditures Price Index, which excludes food and energy—the measure the Fed uses as its preferred inflation metric—is expected to run at 3.4% annualized after last week’s CPI print, which provides inputs into PCE. That data is due September 30. Core CPI, not seasonally adjusted, was 2.4% higher.

For investors, we think the Fed’s action and the new Fed chair’s commentary create some potential decision points:

When to buy bonds: Timing the high in interest rates has proven to be very difficult for investors of all types. With 10-year Treasuries yielding about 5%, funds that offer additional spreads over Treasuries, such as core and core-plus strategies, provide an attractive opportunity for investors to earn extra yield by extending out the curve to lock in historically high yields.

How to judge the economy: Corporate earnings remain strong, and the August jobs numbers were surprising, showing 162,000 new employees and workers enjoying 3.5% annualized wage growth. On a rolling three-month basis, the labor market is stable, absorbing incoming new workers without sparking wage increases.

However, elevated interest rates have pressured lower-income borrowers and slowed the housing market. If the unemployment rate starts to rise, that could ultimately lead to the Fed having to reduce rates, which would bolster the bond prices.

What will happen to fiscal policy?  The media is beginning to take note of the global debt glut now that the U.S. debt has crossed the round number of $40 trillion and the annual deficit exceeds 6% of gross domestic product.

But this story is well understood in the markets. The U.S. Treasury’s move to increase buybacks of long-term Treasury bonds shows that officials are willing to respond to the situation. Long-term investors have also responded, as demand statistics at the most recent Treasury auctions were at all-time highs. Higher yields are attracting buyers.

Meanwhile, with a new chair and now a rate hike, the Fed is trying to demonstrate that it will see inflation down closer to its 2% target. As the bond market works through that in the U.S., global income can diversify portfolios.  

It’s understandable if investors find it hard to look at the past six years’ worth of returns at the index level and be enthusiastic. But while higher yields this year have generated modestly negative returns, they do represent a more attractive entry point for investors.

Investors should be looking at the longer-term potential. Since the last time 10-year Treasury yields were at these levels—in mid-October of 2023—the Bloomberg U.S. Aggregate Bond Index has returned a cumulative 17%. Yields are the best proxy for future returns.

Notes:

All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.