Treasury Bonds: Riding the Range

Last year's volatility in the fixed income markets has carried into the new year. Ten-year Treasury yields remain elevated after surging by about 100 basis points (or 1.0%) since September 2024. There have been many drivers behind the rise in yields. Economic growth has been stronger than expected, inflation's decline has slowed, and there are indications that U.S. government fiscal policy changes could boost inflation and deficits.

The upshot is that there is a wide range of potential outcomes for the bond market in 2025. At this juncture, we see Treasury yields near our estimates of fair value. However, we suggest investors stick close to their benchmark durations and stay up in credit quality, rather than take a lot of interest rate or credit risk, given the high level of uncertainty around policy.

Nonetheless, we see opportunities on the horizon. Bond yields are likely to trade in a wide range as the markets sort through the impact of these various factors. Navigating through the volatility can mean capturing higher nominal and real yields for portfolios longer term. Maintaining some flexibility to act when yields move to the upper end of the expected range can prove beneficial.

The key driver behind Treasury yields is the Federal Reserve. Expectations about the future path of the federal funds rate tend to have the highest correlation with intermediate- and long-term Treasury yields of the factors that we monitor. In turn, those expectations have shifted to reflect how the market views the way the Fed will address growth and inflation.

At the December Federal Reserve Open Market Committee (FOMC) meeting, policymakers cut the federal funds rate (the rate banks charge each other for overnight loans) by 25 basis points, or 0.25%, to a range of 4.25% to 4.5%. At the same time, the Fed's median projections for the future path of the federal funds rate shifted significantly compared to the September FOMC meeting. The FOMC's "dot plot" projection now suggests only two rate cuts of 25 basis points each in 2025 and a longer-run rate of 3.0%.

Market pricing is aligned with the Fed's view for this year but sees the fed funds rate stabilizing in the 3.75% to 4% area. Based on these projections, yields for intermediate- and long-term Treasuries appear reasonable at current levels. Over the past 50 years, the average spread between 10-year Treasury yields and the federal funds rate has been around 120 basis points, but the range has been wide. Nonetheless, since the end of the global financial crisis in 2010, the most frequent readings in the spread have been in the 125- to 150-basis-point range. Consequently, it suggests that a current 10-year Treasury yield near 4.5% would be consistent with the long-term trends, although market expectations suggest yields could move higher.

Another factor suggesting yields are fairly priced or even a bit high is the level of real or inflation-adjusted yields. Using the Treasury Inflation Protected Securities (TIPS) market, real yields are in the 2.25% to 2.5% region—above the Fed's 2% inflation target. Those are the highest yields in more than 15 years. That means an investor who buys and holds a TIPS to maturity would get a yield of 2.25% to 2.5% in addition to the nominal inflation rate over the life of that TIPS.

A third factor supporting current valuations is the declining trend in global bond yields. Due to the relative strength of the U.S. economy, the level of U.S. rates is high compared to other countries and the value of the U.S. dollar is very strong. Those trends appear likely to continue, which should underpin demand for U.S. Treasuries in the global market.

Given the valuations, why are we hesitant to extend duration? Policy risk. Tariffs, immigration policy changes, and tax cuts could all add to inflationary pressures down the road. It is too early to know what the choices will be, but we expect the markets to be wary until there is more clarity.

The rising risks are showing up in the "term premium"—the extra yield that investors demand to hold longer-term Treasuries as compared to a series of short-term Treasuries. It can be thought of as the market's price of uncertainty. The term premium for 10-year Treasuries has moved up from negative 25 basis points last fall to nearly 50 basis points as of Jan. 2, 2025. It reflects the market's concerns about the potential for a shift in the outlook.

The move up of 75 basis points is providing investors with more compensation now than a few months ago, but we are concerned that it could move higher. In the period leading up to and directly after the financial crisis, it averaged between 100 and 200 basis points. We doubt another major move up is likely, as most of the worries about inflation are largely reflected in the recent rise in yields, but with policy uncertainty high, we remain cautious.

Assuming that the Fed cuts the federal funds rate by 50 basis points this year to an upper bound of 4% and inflation edges lower, we estimate that the upper end of the range for 10-year Treasury yields would be about 5%. Barring any major policy surprises, we would view that as an opportunity for fixed income investors to add to the duration in their portfolios. For now, we prefer to be somewhat more cautious about duration and look for opportunities in the months ahead.