Treasurys Off to Their Best Start to the Year Since 2001

A trader on the floor of the New York Stock Exchange at the closing bell in New York on Dec. 30, 2022. (Timothy A. Clary/AFP via Getty Images)

The U.S. Treasury market is off to its best new-year start in two decades as investors purchased government debt with expectations of the Federal Reserve slowing down its tightening efforts.

The benchmark 10-year yield tumbled 10 basis points, to 3.78 percent, on Jan. 3, the sharpest decline on the first trading session of the year since 2001. Yields continued heading lower in the middle of the holiday-shortened trading week, with the 10-year bond sliding nearly 9 basis points, to around 3.70 percent.

The rate-sensitive two-year yield also dropped nearly 4 basis points to around 3.7 percent, while the 30-year bond fell roughly 8 basis points to 3.81 percent. When bond prices rise, yields fall.

Many factors are currently driving the bond market’s momentum: investors on the hunt for attractive yields at a lower risk, a potential peak or end to the Fed’s tightening cycle later this year, and inflationary pressures subsiding.

Put simply, as managing director and chief fixed income strategist at the Schwab Center for Financial Research Kathy Jones stated last month: “It has been a long time coming, but 2023 looks to be the year that bonds will be back in fashion with investors.”

Where Will Treasurys Head in 2023?

Following last year’s historical losses, bond returns are likely to rebound in 2023, says Dave Sekera, chief U.S. market strategist for Morningstar Research Services.

Sekera forecasts that the fed funds rate will average 4.33 percent throughout 2023 and that the 10-year Treasury yield will average 3.5 percent.

“Over the next few months, we could see the yield increase slightly based on the impacts of ongoing quantitative tightening and high inflation, but our forecast is that the interest rate on 10-year Treasurys will end the year below its current level,” he wrote in a note. “For the first half of 2023, the middle of the yield curve (three- to five-year maturities) appears to provide the greatest amount of yield for the least amount of duration risk.”

The U.S. Treasury Department building at dusk in Washington, on June 6, 2019. (AP Photo/Patrick Semansky/File)

In the second half of the year, investors might expand their duration in long-dated bonds.

Bryce Doty, senior vice president and senior portfolio manager at Sit Investment Associates, also agrees that bonds will be “more attractive” in 2023 while stocks struggle.

He anticipates that bonds will generate a decent income “with the potential for price appreciation as yields come off their peak,” adding that core bond funds could result in total returns as high as 8 percent this year.

In addition, according to a note from BMO Capital Markets rates strategists Ian Lyngen and Ben Jeffery, “the next leg of the repricing” will be led by the financial markets reading through the ADP employment print and the December non-farm payrolls report.

Comparable to what happened more than 20 years ago, the financial markets believe that the U.S. central bank will start reducing the size and frequency of rate hikes. Fast forward to the present, and there’s also a growing chorus of economists and market analysts who think the Fed could slash interest rates as early as the middle of the year amid softening of the economy.

“The most inverted yield curve in more than 40 years demonstrates market expectations that the Fed will cut its target rate more quickly than current guidance from the Fed,” Fannie Mae economists said in a report. “Given that we are expecting a general downturn to occur, we see market expectations for the Fed to start cutting rates mid-next year as plausible.”

But Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, estimated that the policy rate could peak at 5.4 percent, higher than the dot-plot’s 5.1 percent estimate.

“All pivot doubters may need to recall that, just over a year ago, Fed members predicted fed funds would be less than 1 percent in November of this year!” Doty noted.

On the recession front, the gap between the two- and 10-year yields inverted to roughly negative 70 basis points. The Fed’s preferred indicator—the three- and 10-year yield curve—inverted to about negative 40 basis points.

The yield-curve inversion, which has been considered a reliable indicator for future economic activity, highlights when long-term interest rates fall below short-term rates, suggesting that investors are transitioning away from short-term bonds and into long-term instruments.

Will a Rebound Happen ‘for the Wrong Reasons’?

As a result of the selloff in 2022, these investment vehicles could “restore their roles as effective portfolio diversifiers,” Eric Leve, chief investment officer at investment firm Bailard, told The Epoch Times.

“With 10-year Treasury yields currently at about 3.75 percent, they provide much richer starting income than they have been in more than 10-years (remember though much of 2020 these yields were between 0.50 percent and 1.0 percent),” he said. “With that, higher-yield bonds can also provide better diversification with stock returns than they have over the past year.”

According to Peter Toogood, CIO at Embark Group, government bonds are likely to increase this year but “for the wrong reasons.”

He recently told CNBC that shifting from quantitative easing to quantitative tightening in 2023 would send bond yields higher since governments will be issuing more debt since central banks are no longer purchasing.

“The inflation data are great. My main concern next year remains the same. I still think bond yields will shift higher for the wrong reasons ... I still think September this year was a nice warning about what can come if governments carry on spending,” he said.

In September 2022, the Bank of England hit the pause button on its tightening and temporarily bought long-dated bonds to “restore orderly market conditions.” This was in response to yields on UK government bonds (gilts) spiking, and the British pound cratering against the U.S. dollar as investors panicked following the government’s deficit-financed mini-budget.