Developed markets fixed income outlook: U.S. treasuries lead the way amid renewed investor interest

This article was produced in partnership with Franklin Templeton.

As we move into the latter half of 2024, the global bond market has returned to a more historically typical environment, with income once again driving performance in fixed income. Developed market bonds, particularly U.S. Treasuries, are currently offering both income and value. Jack McIntyre, portfolio manager at Brandywine Global, emphasizes, “Income in fixed income is back to being a driver of performance,” highlighting the renewed potential in these markets.

Advisors now have a more optimistic answer for clients, as market dynamics continue to shift. The Federal Reserve has suggested it will start its interest rate cutting cycle in September, reflecting a growing expectation of easing policies. This adjustment comes on the heels of persistent inflation in the U.S., where stronger-than-expected economic performance pushed yields on 10-year U.S. Treasuries up from 3.8 percent in December to about 4.7 percent in April, before they settled back down to around 3.8 percent in August.

Meanwhile, the Bank of Canada has already made its first set of rate cuts resulting in a notable decrease of about 85 basis points in yields on 10-year government bonds from their peak of 3.85 percent earlier this year. As a result, the sentiment around bonds has become more positive than it has been in quite some time.

The case for U.S. treasuries

The conditions appear favorable for moving out of cash and positioning further along the Treasury curve. McIntyre notes, “During the second half of 2024, we believe the time will be right to move out of cash and to position farther out on the Treasury curve.”

With the Federal Reserve’s next rate cut, some of the over $6 trillion currently held in money market funds will be redirected towards U.S. Treasuries. Given the current high valuations in the equity markets, it seems unlikely that these funds will flow into stocks. The central bank’s recent communications suggest a gradual, nuanced approach to lowering rates, potentially more so in 2025 than in 2024. Historical precedent indicates that a more substantial rate cut could occur if the economic conditions worsen unexpectedly.

McIntyre highlights, “We like the return potential of longer-dated U.S. Treasuries,” citing the attractive coupon rates that provide a steady income stream over time. Unlike cash, which does not benefit from time, longer-dated Treasuries also offer the added advantage of potential price appreciation should the Federal Reserve be forced to cut rates more aggressively.

One of the critical indicators for predicting Fed actions is the U.S. labour market data, particularly initial and continuing jobless claims. Recent trends in this data point to a weakening labour market, which supports an increase in the unemployment rate observed over recent months. McIntyre points out, “If it comes down to only one economic data point, initial/continuing jobless claims in the U.S. would be the series that warrants watching," emphasizing the labour market's importance in the Fed's decision-making process.

“One way to think of longer maturity bonds, i.e., 10- to 30-year, is as a low-cost insurance policy on something going wrong with the economy,” McIntrye says. This approach is based on the belief that in two out of three scenarios—whether the Fed holds rates steady or cuts them—U.S. Treasuries are likely to offer positive returns. However, there is one scenario where these bonds might underperform: a “fat-tail” event, which is an unexpected and highly unlikely strong rebound in economic growth accompanied by a recovery in inflation. In such a case, the Fed might be compelled to hike rates, which could adversely impact bonds.

The economy is becoming more divided between lower-income, non-asset-owning consumers who are under increasing financial strain, and their wealthier counterparts. This economic divide may signal potential challenges ahead, as such divergence is not sustainable and could indicate further weakening of the economy.

Additionally, the performance of the equity markets is sending cautionary signals. The underperformance of cyclical stocks and a potential negative wealth effect might suggest a shift from an anticipated soft economic landing to a harder one. Fiscal constraints add another layer of complexity, as high interest costs are likely to limit essential government spending, complicating the fiscal policy landscape further.

Additionally, another risk factor that could affect the bond market is the outcome of the upcoming U.S. election. A sweep by either political party could result in increased government spending or tax cuts, both of which could have negative implications for developed market bonds and U.S. Treasuries in particular.

McIntyre anticipates election-related market volatility to kick off earlier than usual this year.  “Our base case is that we get a divided government no matter who wins the White House,” McIntyre says, “That would be the best-case scenario for markets. A divided government curtails new major spending programs and tax cuts.” There's no straightforward way to hedge against election volatility, so taking smaller positions may help manage potential price swings. Given past inaccuracies in election polls, uncertainty remains high for this cycle.

The global bond landscape

Looking beyond the U.S., several developments in the global bond market warrant attention:

• Japan: The Bank of Japan’s lack of a definitive plan to address inflation concerns creates uncertainty, making Japanese government bonds less attractive.
• Eurozone: European bonds generally trade at a premium to U.S. Treasuries, but a slowdown in the U.S. economy could lead to a divergence, with Treasuries potentially outperforming.
• UK: On a relative basis, UK gilts could outperform core eurozone bonds in the second half of 2024, with current spreads versus German debt appearing attractive.
• China: China continues to be a source of global deflation as it attempts to export its way out of economic challenges. The country's structural issues suggest ongoing deflationary pressures.

McIntyre predicts the “year of the coupon” is likely to persist. Developed market bonds, particularly U.S. Treasuries, offer meaningful value due to attractive coupon rates and potential for capital appreciation in a declining rate environment. However, investors should brace for increased volatility in the second half of the year as political factors begin to overshadow economic ones.

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Franklin Templeton Canada is a business name used by Franklin Templeton Investments Corp. Brandywine Global is an affiliate of Franklin Templeton Investments Corp.