Interest rate movements, whether due to data releases or Fed policy announcements, have been one of the main market drivers in 2024. Rather than speculate about the direction of Fed policy or obsess over every economic release, we look at what type of economy and Fed policy is priced into the markets, then gauge if that is reasonable. Assuming 2% inflation and 2% trend growth (the Fed’s two long term assumptions), we get a 4% neutral interest rate, bracketed by a 50 bps 3.75% to 4.25% neutral range. Second, we look at the 2yr yield as a proxy for Fed policy, and the 10yr yield as a proxy for the economy. Based on where the 2yr is relative to our neutral range, we can gauge the market’s view of Fed policy, while the 10yr shows what type of economy the market is pricing.
Chart 1 shows these two rates, as well as an orange “Hot Economy, Tight Fed” range of 4.25% to 5.00%, and a blue “Cool Economy, Loose Fed” range of 3.00% to 3.75%.
During Q4, despite the Fed cutting rates twice, the 10yr returned to the “hot economy” range, rising to 4.57%, while the 2yr drifted up to the top of the neutral range, at 4.24%. This prices a neutral Fed and a solid economy. Both are reasonable expectations.
Chart 1
Bonds had a challenging 2024, because they entered the year with rates reflecting a slower economy and a looser Fed than was likely. Entering 2025, what do valuations say about the appeal of bonds at this interest rate level? For valuing bonds, one metric we focus on is the ratio of Duration to Yield. Duration measures the sensitivity of a bond’s price to changes in interest rates, with the value representing the percent change in a bond’s price for a 1% change in rates. For example, a bond with a duration of five would lose 5% if interest rates rose 1%.
The ratio of Duration to Yield compares interest rate sensitivity to the income it offers. This ratio for the Agg is to the left. Before the Global Financial Crisis in 2009, it was in a range of 1.0 to 1.4, but in the post Global Financial Crisis period, it was between 2 and 4, then rose above 6 during covid. During the two recent highs for interest rates (October 2023 and April 2024), the yield on the Bloomberg Barclays Aggregate (Agg) exceeded 5%, and the Duration/Yield rate finally returned to the 1.0 to 1.4 range.
Chart 2
The Agg’s yield rose to 4.9% In Q4, causing its price to decline and leaving it with flat returns for 2024, but lowering the Duration to Yield ratio back down to 1.3, the upper end of the pre-GFC range. The good news is that higher yields (and a lower Duration to Yield ratio) sets up the bond market for a better 2025.
In addition to Fed policy and the duration to yield relationship normalized to pre-GFC levels, another sign of interest rate normalization is the yield curve. Typically, short term rates are lower than long term rates. However since 2022, the 2yr Tsy yield has been higher than the 10yr. The 2yr fell below the 10yr in September, joined by the 1yr in November. Driven by a concept known as the “term premium”, an upwardly sloped yield curve encourages investors to lend longer term by offering better compensation for taking on potential interest rate volatility, as opposed to sitting in short term debt. It allows the banking system to function more smoothly as well.
Overall, as the Fed has raised rates and the markets have adjusted, the bond market, which has been distorted for more than a decade, seems to be returning to normal. While a positive for functioning capital markets and investor portfolios, there are two issues.
First, the economy needs to adjust to higher rates as well. Mortgage and auto financing rates, for example, are not as low as they have been. Second, market participants need to adjust, as well. Bond investors should not expect rates to plummet to near zero again, and so should not be expecting excess return from duration.
The 10yr and 2yr reflect a reasonable economic and Fed outlook; the duration to yield ratio is back to pre-GFC levels; the yield curve is no longer inverted. These three factors have not all been “normal” at the same time for 15 years. That is why Unusually, Interest Rates Look Normal.
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