While 2023 was a year dominated by speculation about when the Federal Reserve would end its hiking cycle, 2024 shifted focus to when the Fed would cut overnight rates and thereby begin to ease policy from the 5.25%-5.50% range, the highest level in almost 25 years.
As inflation readings rose to as high as +3.5% on Headline CPI in Q1, 10yr Treasuries sold off to 4.7% and market participants became quite uncertain as to whether the Fed was going to be able to cut in 2024 at all. However, as we’ve become accustomed to over the past few years, yields made another sharp reversal, this time lower, coinciding with a rise in the unemployment rate above 4% and a decline in headline CPI to +2.4% by the Summer. The 2yr and 10yr traded to year-to-date lows in yield of 3.54% and 3.62% in September as expectations of Fed cuts ratcheted back up.
With declining inflation and weakening employment data, the Fed initiated a cumulative 100 basis points of easing beginning in mid-September and with 25bps just a few weeks ago. The interesting thing for bond investors is that this 100bps of easing in policy has seen a 100bp rise in 10yr yields. Even the 2yr, which is more sensitive to Fed policy, has risen from the low 3.50%s to north of 4.30% as the Fed cut Rates.
At Meritage, we maintained throughout late-2023 that barring an economic shock, the Fed’s current easing cycle would likely start slowly and pause or end in a higher place than those of the recent past. This served us well in 2024 as we handily beat both our Short and Intermediate benchmarks with duration underweights. Q4 was particularly difficult for investors with longer maturity bond portfolios, incurring losses in the 3% range, wiping out half of the year’s gains. Our hesitancy to extend ahead of the election protected client portfolios in Q4 and allowed us to notch another year of solid returns in fixed income.
Turning to credit markets, while volatility remained prevalent in rates, investment grade credit spreads saw a slow grind tighter. We did participate with an overweight in BBB debt which ended 27bps tighter on the year. Our short duration positioning helped here as well with our taxable bond portfolios soundly outperforming the +3.6% return of an all-BBB portfolio with the added ballast of a substantial weighting to US Treasuries. In the municipal market, a very choppy year with rates and eked out a slightly positive return on the index of +1.6%. We capitalized on select Q4 sell-off opportunities aligned with our preferred corporate issuers on a tax-adjusted basis in the Q4 rate selloff, but clear value in Munis continues to be in longer maturities where we are still cautious.
Looking ahead to 2025, the fixed income landscape remains as murky as it was in 2023 and 2024 with a wide range of views particularly on the Fed. The market is currently pricing in less than 2 additional rate cuts in 2025 from today’s 4.25% – 4.50%. Unemployment has actually ticked down and CPI up since the Summer, albeit by a small amount. Risk assets have rallied and credit is plentiful. Furthermore, we have a new Administration coming in that is not shy to make policy changes, and the unsustainable US debt and deficit situation is not going away.
On the flip side, elevated yields appear likely to persist rewarding bond investors and augmenting equity portfolios. Additionally, our current conservative positioning on duration and credit exposure makes this uncertainty a potential opportunity for our clients. We look forward to navigating the fixed income markets for you in 2025.
