Volatility, velocity and vigilantes

Volatility is how markets express uncertainty, and 2024 offered its share of ups and downs. After a choppy start to the year, and a rally through much of Q2 and Q3, the Bloomberg US Aggregate ultimately gave up a portion of year-to-date (YTD) return in Q4, while remaining modestly positive for the year at 1.25%. Growing investor expectations of a Trump win fueled a risk rally in the weeks before the election (higher rates/tighter spreads), defining the quarter and creating the negative total returns. It wasn’t quite 2016 all over again, but the net result was very similar. During this past quarter, the 10-yr Treasury yield moved up 77 basis points, while in Q4 2016, the 10-yr Treasury yield moved up 84bps, albeit all coming after the election surprise. Also similar was a steepening of the yield curve which occurred in both post-election environments, a likely result of some of the increased market uncertainty over future policy effects. Adding to the uncertainty, the FOMC reduced anticipated velocity, halving 2025 rate cut expectations during their last meeting on December 18, effectively dampening appetite for risk assets in the last few weeks of the year.

Yield dynamics dominated

In spite of challenges in Q4, most of Federated Hermes fixed income strategies ended the year with competitive performance. We attribute this in large part to our diversified alpha process which relies on adding value through a variety of decision areas. The rate side had the largest impact as our Yield Curve committee’s conviction in the ultimate steepening of the curve and the Duration pod’s tactical moves on both sides of neutral proved to be profitable, particularly in the second half of the year. 

On the Sector side, we held to our view throughout 2024 that corporate investment grade and high-yield spreads are historically tight and valuations rich. Over the recent tightening, pause and rate-cut cycle, that caution has not been rewarded, but we believe the risks remain heightened. We’ve been able to help offset those underweights in our Core Plus portfolios to some extent with overweights during 2024 in MBS, a sector that has been positive in spite of rate volatility, and emerging market debt (EMD), which has also had a strong run recently. 

Three and done? It could happen…

We are reminded of a time a few decades back, and well before the more recent zero bound days, when the US 10-year note was trading roughly in the range it has been recently. During the Clinton administration, the bond market got a little ahead of itself as the FOMC twice began a fed funds rate-cutting cycle, then paused for several months only to reverse course and raise rates. We see possible similarities based on the way Chair Powell discussed the reduction in the committee’s rate cut projections at his most recent press conference. 

Along with the possibility of no rate cuts in 2025 (or even a remote possibility of a hike if inflation continues to disappoint like it did in Q4), we could be in for a period where coupon rates drive bond returns. While this would also be reminiscent of Trump 1.0, the good news is that yields are now roughly twice what they were in 2017, and the yield curve is re-establishing its more normal curve shape. That could allow for reasonable absolute bond returns, albeit in the form of a bear steepener with the long end of the yield curve selling off in stages as short end rates are more static. 

What might be ahead

Economic conditions are more complicated than they were nearly 30 years ago. The economy is stronger than expected, driving exuberance and inflation concerns, but there are also far more political and policy unknowns. The Clinton administration enjoyed a thriving economy and prioritized and then achieved a balanced budget. But the current dynamic involves worsening budget deficit concerns, a host of new influencers and the potential reappearance of the bond vigilantes—known to sell treasuries in protest of deficits. Perhaps the newly described DOGE effort will make progress on the deficit, but it is an uphill climb unless Trump gives Musk and Ramaswammy the green light to tackle entitlements and defense spending.

Sequencing matters

In this regard, sequencing may matter. Tariffs and other protectionist policies will likely provide at least a short-term boost to inflation while deregulation and energy policies should have positive effects. Tax cuts have historically increased deficits while immigration reform could produce long term labor force stability, but also short term disruption. It seems likely that the Fed will factor in the new administration’s policies as they unfold. Powell appears to have already opened the door, and for at least a few FOMC members, it seems to have been a factor in adjusting their December dots.

Will others join the chess match?

And finally, some investors believe that Trump will be able to keep both the stock and bond markets happy—positively correlated and moving upward in price. The thinking behind a “Trump put”—he is playing chess while other economies and markets are playing checkers—has already begun to show some chinks in December’s price action. It still may be the case, but having seen the playbook before, affected parties better understand the exercise and thus accordingly will plan differently, adding one more potential disruptive factors into the mix of uncertainties.