In the economic outlook released during last week's Federal Open Market Committee (FOMC) monetary policy meeting, the Federal Reserve raised its inflation expectations for this year and maintained its expectation of three interest rate cuts within the year. However, market participants believe that due to a slight rebound in US inflation and unclear prospects, the Federal Reserve remains highly cautious about the timing of interest rate cuts, and the path of interest rate cuts remains uncertain.
In this context, investors in the US bond market have been flocking since before the meeting and are expected to continue to flock to medium-term US government bonds. The uncertainty of the Federal Reserve's policy path forces investors to find the best point between seeking returns and controlling risks.
According to Morningstar Direct data, in the first two months of this year, medium-term US government bond funds, including US treasury bond bonds and bonds issued by relevant government agencies, attracted a net inflow of US $9.8 billion. During the same period, long-term US government bond funds had a net outflow of $2.3 billion, while short-term government bond funds had a net outflow of $3.5 billion. The data also shows that as of the end of February, the managed asset size of the US midterm government bond fund reached a historical record of $252 billion, with a growth rate of 2% within the year. In contrast, the asset management scale of US short-term and long-term government bonds decreased by 3.8% and 2.7%, respectively, to $93.4 billion and $158.3 billion.
The current round of panic buying for medium-term US bonds is mainly driven by a shift in expectations for the Federal Reserve's policy. At the beginning of 2023, the Federal Reserve's aggressive rate hikes led to an inverted yield curve, prompting investors to seek short-term bonds to earn returns. As bets on interest rate cuts intensified in the second half of last year, investors flocked to long-term bonds, pushing their prices higher and generating capital gains. The situation has changed again this year. As the Federal Reserve confirms that it will cut interest rates within the year, but inflation remains sticky, the market has lowered its expectation of rate cuts from six at the end of last year to three, once again reshaping the investment strategy of the US bond market.
Michael Parnell, Senior Strategic Research Analyst at Verus, said, "The uncertainty of interest rate paths may be a driving factor for investors to shift towards the middle of the yield curve, as investors desire sustained term exposure but lack sufficient confidence in the Federal Reserve's rate cut path, believing that it cannot go further on the yield curve."
Christian Hoffmann, portfolio manager at Thornburg Investment Management, told First Financial reporters that the Federal Reserve is hinting that they may quietly abandon their 2% inflation target and be willing to bear higher inflation rates. "Therefore, the market recently expected to cut interest rates six to seven times this year, but the consensus now is three times, or even only two times."
In Hoffman's view, although this rate cut is reasonable from an arithmetic perspective, the market still needs to pay attention to two other possible paths: if the current economic data trend remains unchanged, it may ultimately only be cut once or not. On the contrary, if economic data drops significantly, there is a chance that the rate cut will be pushed back to nearly five to six times. He stated that it is precisely this uncertainty that has led to significant fluctuations in the 10-year US Treasury bond that have not been seen since 2007. Overall, the US bond market will continue to struggle between expectations of interest rate cuts and the Federal Reserve's greater tolerance for inflation, with the former favorable for bonds and the latter unfavorable for bonds.
However, medium-term bonds can provide the optimal choice in this dilemma. Firstly, it helps investors benefit from the current high yield within a reasonable period of 4-10 years. Secondly, while the yield remains high, it reduces the investment risk associated with a significant decline in long-term US bond prices.
Erin Browne, Managing Director and Multi Asset Portfolio Manager of PICMO, had told First Financial reporters earlier this year that he expected the Federal Reserve to lower interest rates for the first time later than expected by the market last year. "Due to the unclear policy outlook of the Federal Reserve and the large issuance of new bonds by the United States in order to balance the fiscal budget, the end of the yield curve, namely long-term and ultra long term US bonds, will be under pressure. Although this pressure is controllable, it does lead investors to be more inclined to buy the 'belly' of the yield curve, namely the 5-year US bond. Brownie said," In addition, Pinhao has also favored investments in steeper yield curves this year, especially in the 5-year and 30-year US bonds. ".
Karen Manna, portfolio manager at Federated Hermes, also predicts that "medium-term Treasury funds will continue to attract more cash flow in the coming quarters, as considering the trend of Treasury prices and investment maturities, medium-term Treasury bonds can maintain a risk return balance and ultimately provide an attractive overall return rate."