Even With Fewer Rate Cuts, You Should Still Buy Bonds

Traders on the floor at the New York Stock Exchange.
Traders on the floor at the New York Stock Exchange.

Summary

Markets were too gung-ho about how much the Fed would cut rates this year. But savers with long investment horizons still shouldn’t miss out on the opportunity to lock in 4.5% fixed-income returns.

Whether investors expect too many interest-rate cuts or too few depends on what time frame you are looking at.

Both stocks and bonds sold off earlier this week after the latest U.S. consumer-price figures sparked fears that central banks across the developed world may struggle to win the “last mile" of the inflation battle. Panicking would be premature: The surprising strength of the U.S. economy is more important for stocks than rates are. Indeed, stocks have already clawed back most of their losses.

For bonds, though, expectations of monetary policy matter a lot more. Investors have been unrealistic. Only two weeks ago, they were convinced that the Federal Reserve would start lowering borrowing costs in March, and priced in a 66% chance that there would be at least six quarter-percentage-point cuts by the end of the year, an analysis of derivatives contracts by CME Group suggests. Officials pushed back against market optimism in vain.

The inflation data has finally brought home the point. Derivatives markets now show a 35% chance that borrowing costs will be 4.5% or higher by year-end—implying four rate cuts or fewer. Yields on one-year Treasury bills have risen to around 5%, which suggests that investors expect rates to be at that level on average during the next 12 months. It looks more reasonable.

Superficially, this makes short-term debt attractive: Savers can buy it and, a year from now, they will probably have gotten a similar return than if they had parked the cash in a money-market fund or a bank deposit—probably even a bit more. Long-term bonds look unappetizing in comparison: 20-year Treasurys yield just 4.5%, and require locking the money away for two decades.

Yet this rate is still very high relative to what was available not long ago. And locking it in might be precisely the point. Once the Fed and other central banks start lowering borrowing costs—even if they do so by less than previously thought—returns on short-term and long-term debt will fall. Investors who then try to switch out of bills into bonds may find that it is too late.

For long-term investors, therefore, the key question is where rates will be once inflation returns to target, regardless of whether it takes longer than expected. In their median December projection, Fed officials said this number is 2.5%. However, the rate implied by 20-year Treasurys once the first 10 years are stripped out is 4.8%.

So, in the same way that the Fed’s “dot plots" were warning investors they were being too gung-ho about short-term rates, they are also suggesting excessive pessimism about the long run. This would make bonds, not bills, the better buy.

To be sure, the Fed could be wrong. More activist fiscal policy, a partial reversal of globalization and constant geopolitical turmoil may well be the new status quo, in which case inflation and rates could remain higher. Some officials are taking this view: The high range of the Fed’s long-run rate projections has already been moving upward, rising to 3.8% last September.

Another problem raised by Wall Street doomsayers is that Treasurys may not properly reflect rate expectations, perhaps because investors are now less eager to hold long-term assets or because yields are being impacted by fears that governments are issuing too much debt. In their favor, interest-rate swaps—an alternative measure of policy expectations—are actually trading around officials’ high-range forecast.

But Fed estimates show that investors still aren’t demanding much of a premium relative to rate expectations to hold Treasurys. This belies the idea that markets are dumping them for other reasons. Also, the evidence suggests that all of the extra debt issued by Washington that banks are having to stockpile isn’t pushing up bond yields, but rather artificially depressing yields on swaps, which are used to hedge the risk.

Investors often fixate on how the whims of monetary hawks and doves have an outsize impact on the price of long-term bonds, which can be dangerous for those who need to sell them in a pinch. But savers with long investment horizons need to remember the opposite too: Missing out on a fixed return of 4.5%—5.6% if they venture into long-duration investment-grade corporate debt—could be something they come to regret.

Write to Jon Sindreu at jon.sindreu@wsj.com

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