Bonds Slip in the Fourth Quarter, but Post Second Consecutive Annual Gain
Core bonds ended the fourth quarter down 3.10% due to rising interest rates. Corporate bonds once again outperformed with excess returns of 1.01% in the quarter. Mortgage-backed securities slipped in the quarter and lagged Treasuries by a couple basis points. For the year, corporate bonds were the big winner with excess returns of 2.8% versus Treasuries. The core bond index ended the year with a total return of 1.35%, which marked the first back-to back positive annual gains since 2020.
The 10-year Treasury began the quarter at 3.78% and the market pricing in a 3% Fed Funds rate to end 2025. The Fed was quite dovish throughout the second quarter in reaction to a modestly higher unemployment rate and better inflation readings. However, the market was too focused on Fed rhetoric despite improving economic data. The Citigroup’s Citi Surprise Index (CSI) would make a 90-point swing from -47 to +43. Yields began to move higher as low jobless claims persisted and forward GDP estimates remained robust. The CSI peaked in mid-November and bond yields peaked at almost the exact same time. Then the Fed meeting in December acted as a catalyst to further push up yields with the 10-year finishing at 4.56%.
At the December Federal Open Market Committee (FOMC) meeting the Fed Funds rate was lowered by 25 basis points to 4.5%. The Fed’s projections for 2025 cuts were reduced from 4 to just 2. Fed Chair Powell even noted that the decision to cut in December was a close call. Bond yields spiked and stocks sold off. The Fed Funds expected level shifted from 3.0% to 3.9% to end 2025 and pulled the entire Treasury curve higher.
Portfolio Positioning
We moved duration from underweight to neutral after the CSI peaked. There is a consensus crowded trade that domestic growth will be robust in 2025 given the new administration’s policy rhetoric. Yields would likely move lower if there is any crack in this narrative. China has seen their bond yields plunge as the country faces serious economic problems. Most participants still expect China to unleash the liquidity bazooka, but they appear to be targeting different policy goals. Weakness in China, if sustained, will impact global growth and inflation.
On the domestic front, housing appears to finally be buckling under the weight of higher mortgage rates. Homebuilders have underperformed the S&P 500 by nearly 20% from their peak in September. The last time this occurred was in March of this year and the 10-year Treasury yield fell during the underperformance and an additional 66 basis points after homebuilders bottomed. This time around, the 10-year is 80 basis points higher. The CSI has now gone from +43 to +2 and looks to be giving a clue that the market is again too focused on the Federal Reserve dot plot. The Fed has repeatedly said they are just going to react to the data.
It is likely that the portfolios will increase duration during the quarter. We expect yields to track growth and the Fed to ultimately cut more than expected and be reactionary to the growth outcomes. The portfolios remain in a reduced credit stance, which is around the neutral level versus the benchmark.
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