The market gives up on rate cuts

Bond investors started the year pricing six Federal Reserve rate cuts. They have now priced out almost all of them. The ten-year Treasury yield has climbed to 4.70 per cent, pulling mortgage rates back toward eight per cent and knocking equity valuations lower.

Six cuts, then almost none

The repricing has been thorough and costly. Investors who loaded up on duration late in 2023, expecting quick capital gains, are sitting on heavy mark-to-market losses. With policy rates stuck above five per cent, the whole Treasury curve has shifted as the market accepts that policy will stay restrictive for some time.

How the rally was built

The bet looked sensible at the time. The ten-year yield touched 5 per cent in October, then fell sharply through November and December as inflation cooled and the Fed signalled that its next move would probably be a cut. By the turn of the year the yield had dropped below 4 per cent, and the futures market was priced for easing to begin as early as March. Buyers of long bonds booked quick gains and extrapolated them into the new year.

The extrapolation assumed that disinflation would continue at the pace of late 2023. Instead the economy kept growing, employers kept hiring and three consecutive monthly inflation reports came in above forecasts. Each report pushed the expected first cut further out, and each postponement took a slice off the value of long-dated bonds. The move has been orderly, with no single day of panic, which is part of why its cumulative size has surprised some holders.

Why duration hurts so much

The loss mechanism is mechanical. A bond's price moves inversely to its yield, and the longer the maturity, the larger the move for any change in rates. A thirty-year Treasury bought at the turn of the year has lost far more than a two-year note, because its fixed coupons are discounted over many more years. Investors who bought long maturities specifically to maximise their gain from falling rates have discovered that the same leverage works in both directions.

Some of the pain sits with institutions that cannot easily absorb it. Banks that hold Treasuries in their securities portfolios see unrealised losses widen again, the problem that brought down Silicon Valley Bank in March 2023 when depositors fled and the bank had to sell bonds at a loss. Insurers and pension funds are better matched, since their liabilities also fall in value when yields rise, but mutual funds and exchange-traded funds that track long-dated indices pass the losses straight to their holders.

Supply adds weight

Monetary policy is not the only force at work. The federal government is running a deficit well above 5 per cent of output with unemployment below 4 per cent, so the Treasury must sell record amounts of debt. Last August it raised the size of its quarterly coupon auctions, and in the same week Fitch cut America's credit rating to AA+, which helped trigger last autumn's sell-off. When the Fed is also shrinking its balance sheet rather than buying bonds, private investors must absorb that supply, and they demand a higher yield for doing so.

That extra compensation, the term premium, had nearly vanished during the years of quantitative easing. Its return means long yields may not fall as far as short rates when cuts eventually come. The next quarterly refunding announcement, due at the start of May, will show whether the Treasury intends to lift auction sizes again or hold them steady. Treasury officials said in February that they did not expect further increases for at least several quarters, so any change of tone would be read as a warning. The Fed's own decision on slowing the pace of its balance-sheet run-off, which officials discussed in March, bears on the same question from the demand side.

Winners from higher yields

The repricing has beneficiaries. Investors who stayed in short-dated bills and money market funds continue to earn more than 5 per cent with almost no price risk, and they have been paid for their patience. The dollar has strengthened as rate differentials with Europe and Japan have widened, and the yen has slid to its weakest level against the dollar in more than three decades. That makes American imports cheaper and puts pressure on countries and companies that borrow in dollars but earn in other currencies.

The losers extend beyond bondholders. Homebuyers facing mortgage rates near their highest in two decades have pulled back, and housebuilders' order books reflect it. Highly valued technology shares, whose worth rests on profits far in the future, are the most sensitive part of the equity market to higher discount rates. Smaller companies with floating-rate bank debt feel the squeeze directly in their interest bills.

The bull case that remains

The best argument for owning duration now is that the price has changed. At 4.70 per cent, a ten-year Treasury offers a real yield well above what investors accepted for most of the past fifteen years, and it provides insurance against a recession that would force the Fed to cut quickly. Bond rallies often start from moments of maximum pessimism, as in 1995 after the rout of the previous year. A buyer at today's levels needs only for yields to stay flat to earn a respectable return.

The risk is that the rally depends on a slowdown that is not yet visible in the data. First-quarter growth figures and the March inflation data for personal consumption both arrive at the end of April, followed by the Fed's meeting and the April jobs report in early May. Any sign that inflation is re-accelerating would push the market to price the possibility of a further increase, rather than a delayed cut.

Anyone who bought long bonds for the 2024 rate cuts has paid for the mistake. Unless inflation retreats, yields will probably stay near these levels through the summer, and the duration bulls may have to wait until next year for their rally. The likeliest path is a choppy range below last October's high into the autumn, with mortgage borrowers, housebuilders and bank balance sheets carrying the cost until the Fed can credibly promise a cut, and that promise is unlikely before the September meeting at the earliest.