2024 Systematic Fixed Income Outlook - BlackRock

A "new" conundrum for bonds?

The combined impact of all those factors might lead to what we'll call the potential for a new conundrum for bond investors. Recall the old conundrum, coined by then Fed Chair Greenspan during the 2004-2005 hiking cycle at his February 2005 Humphrey Hawkins Congressional Testimony: "The broadly unanticipated behavior of world bond markets remains a conundrum… Long term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target Federal Funds Rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short term interest rates are normally accompanied by a rise in longer term yields."

Today of course, the conditions are reversed. The Fed is broadly expected to cut rates in 2024, and long term interest rates are broadly expected to follow those cuts lower as well. However, the potential for the above outlined factors to assert themselves may lead to lagging declines in long term rates and even the potential for "conundrum" type behavior—where long term rates move higher even as the Fed lowers short term policy rates. 

Now the first scenario where declines in longer term rates are less than the declines in shorter term rates could be considered "normal." Indeed, this expected "steepening" of the yield curve is the consensus view for 2024. But a "twist steepening"—where short term rates fall but longer-term rates rise—would be more of a conundrum as it would be at odds with both expectations and historical experience. However, it is precisely for the structural reasons outlined above that bond market performance may not move in line with historical experience. 

Additionally, when we think about the three types of rate cuts as outlined in the first section (maintenance, calibration, recession), these may have very different implications for the behavior of the long end of the curve. Maintenance cuts particularly have the greatest potential to exhibit "conundrum" curve behavior as these cuts reflect falling inflation without a decline in growth. Under such a scenario, the anticipated benefits from longer duration might fail to be realized. This would mean less demand for portfolio flows to drive long term rates lower—one of the key factors outlined as a structural source of past bond market long end outperformance. 

Under calibration (economic slowing leading to cuts) or recession-induced cuts, we might expect more of a return to "normal" bond market behavior of long end outperformance. While not a conundrum of rising rates, this outcome would still frustrate market consensus outlooks for outperformance in the front end of the curve. Indeed, that market consensus positioning (and its unwinding under this scenario) might contribute to flattening curves under calibration or recession scenarios. 

But there are other scenarios as well to consider. Most importantly, inflation failing to fall as far as consensus expects. Such a scenario would undermine rate cut expectations and consensus positioning for both long duration and steeper curves. Such expectations have become consensus and embedded in market pricing because the inflation data has validated the "immaculate disinflation" narrative where inflation falls without significant labor market or economic weakness. 

Taking the other side of the consensus recession views in 2023 proved to be correct. Taking another contrarian view in 2024 (but this time towards the bearish side) will be correct again if the current inflation trajectory fails to hold.

The current market consensus for 2024 expects normalizing growth and fading inflation to underpin an optimistic case for financial returns as recession is averted, inflation proves transitory, and a soft-landing fuels Fed rate cuts. How could that go wrong? If the current inflation trajectory fails to hold from sticky services inflation and less goods deflation. And stronger than expected growth that holds up inflation expectations could further undermine both expectations for Fed cuts and consensus expectations for financial market returns in 2024.

Implications for investors

Post-COVID structural economic and financial changes may lead to lagged declines (or even increases) in long term rates relative to short term rates as cuts take place. In this "new" regime for bond investors, investors may find better risk-adjusted performance and diversification potential in shorter maturity bonds relative to longer maturities—particularly if a soft-landing economic scenario plays out. Investors may also consider adding sources of defensive alpha that take advantage of today's more volatile and higher rate regime to seek uncorrelated, diversifying returns that can help build portfolio resiliency amid uncertainty.