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Please read important information at the end of this program. Recorded on 01/21/2025.
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CIO views/opinions are subject to change and should not be considered specific investment advice.
Chris Hyzy
Hello, I'm Chris Hyzy. One of the biggest financial stories in early 2025 has been the recent, remarkable surge in long-term bond yields, specifically for 10-year U.S. treasuries.
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Chris Hyzy
Chief Investment Officer
Merrill and Bank of America Private Bank
Chris Hyzy
Bond yields don't always dominate the headlines, but they're now capturing attention for what they say about a strong economy, inflation and the likely path of Federal Reserve interest rate cuts.
Matt, Diczok our head of fixed income strategy, joins me for a look at what's going on and what it means for the economy and investors. Matt, thanks for joining me today.
Matt Diczok
Thanks for having me, Chris.
Chris Hyzy
So let's dive right in, like we always say. Ten-year yields. It's been getting all of the focus really over the last, I would say, quarter or so. But as we moved from 24 into 25 there's this look back that a lot of investors, a lot of clients are asking us about, which is: since the Federal Reserve started to cut rates, ten-year yields are up over 100 basis points, or at least at their peak. What gives?
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Matthew Diczok
Head of Fixed Income Strategy
Chief Investment Office
Merrill and Bank of America Private Bank
Matthew Diczok
So a big change. What's really changed though is not so much the economy. We still see a resilient economy. We still see inflation around 3%. That hasn't changed. What's really changed is the Fed's mindset. With the incoming administration, they really are more concerned about the economy taking off even further, adding animal spirits, more activity. So they're feeling a little bit more pressure to put a little bit more higher rates into the market to help get inflation back down to the 2% level.
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2025 end-of-year Fed funds rate now anticipated to be about 4% versus 2.75% several months ago.
Bloomberg: 11/13/24
So it's not that they're, they're adding to rates or hiking rates, they've just dramatically reduced how many rate cuts they're going to put to the economy. So now as we look at it, at the end of this year, the Fed funds rates are expected to be about 4%. As you mentioned, a quarter or so ago, it was expected to be 275.
So the most massive change is just the expectation that the Fed's not going to do nearly as much as it planned to do six months ago.
Chris Hyzy
And they're still data-dependent. And the data really has been stalled out in terms of their key inflation gauges going in the direction that they wanted. So if you put that off to the side for a second, inflation has remained somewhat sticky despite the last couple of announcements, which show some subtle change back to what they favor, which is a little bit of a downslope.
Having said all that, real growth expanding, nominal growth still attractive even before the new administration takes over. Before we get into that, let's talk a little bit about the difference between real and nominal yields and why it matters.
Matthew Diczok
Gotcha. That's an important question. We see yields in the market like the ten-year. We say for instance right now is around 4.5%. That's just the nominal yield. That's just the yield you see in the market. What really makes a difference is how much is that rate above or below inflation. Because at the end of the day you want bonds to give you a return over inflation.
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Real yield = the amount earned above or below inflation.
Nominal yield = the amount earned before accounting for inflation.
If you're just keeping pace inflation, it's like you're on a treadmill. You're running as fast as you want, you're really not going anywhere, you're still in your basement, right? Now in the market, we actually see real yields, yields above inflation of approximately 2 to 2.5% across the curve. That is a very good opportunity, in our opinion.
Positive real yields, 2 to 2.5%. So that means if you bought a government guaranteed treasury inflation-protected security and you held it to maturity, you could grow real wealth year in and year out without any credit risk. That's a variable, favorable opportunity for investors, in our perspective.
Chris Hyzy
And let's discuss something that you and I talk about a lot, which is the normalization, the normalizing yield curve. What does it actually mean?
Matthew Diczok
So a normal yield curve for us is where longer-term bonds yield more than shorter-term bonds. And that's basically where we are right now that you've gotten to a place where the ten-year rate is higher than the two-year rate, which is higher than the Fed funds rate. That's a more normal shape with slope.
[Chart labeled "U.S. Treasurys — Daily Yield Curve" that shows an upward slope of the yield curve]
Chris Hyzy
Upward slope.
Matthew Diczok
Upward sloping, as we call it. The farther out you go in terms of maturity, the higher yields bond. We got to that place different than we expected. We thought we were going to get there by the Fed cutting rates dramatically. We've gotten it with longer rates going higher. While that might reduce current bond prices, overall, that's more favorable for clients because now they can reinvest at those higher cash flows for a longer period of time.
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With the yield curve normalizing, investors can reinvest cash at higher yields for a longer time.
So we flip it on its head. The fact that the yield curve is normalizing too fast, with long rates going up, might feel bad to folks because their bond prices go down, but now they have the ability to reinvest cash at even higher yields for a longer period of time. That's an unambiguous positive from our perspective.
Chris Hyzy
With all of this under consideration, where yields have come to — where they were — what type of portfolio are you positioning today across fixed income?
Matthew Diczok
For a while now we've been overweight equities based on the valuation picture and the fundamental economic picture we saw, we saw the resilience in the economy and we were more bullish on that than others. We're maintaining that. We're still slightly overweight equities and we're focused on the U.S.
We believe that's the correct position. We're not wildly overweight. U.S. equities. We believe that's quite the right tilt. At the same time, as we said, we feel good about bonds. We still believe a large allocation to fixed income, even though slightly overweight, because we want to put a little more dollars in equities, makes a tremendous amount of sense.
What we don't want clients to be on the fixed income side is too short duration, meaning we don't want a bond portfolio that too, uh, low in terms of maturity, too short. Because if we do get something unforeseen, if we do get an economic downturn, there is the ability for the Fed to start cutting rates again. There is the ability for rates to move lower, potentially — potentially — capital appreciation if the economy suffers.
So because they are well valued right now, we want to maintain that equity overweight. But we also want to maintain at least a strategic duration target of neutral. Do not be too short on fixed income, because then you won't get any benefit from investing at these higher yields for a longer period of time. We don't want clients to miss that opportunity.
Chris Hyzy
Okay, Matt, we've covered a lot. What other questions could there be that clients should be asking their financial advisor?
Matthew Diczok
So really comes down to the personal situation the client finds themselves in. For instance, let's take a client in or close to retirement. That client I want to ask more about fixed income, about weighting more towards fixed income, about potentially longer-duration bonds, take advantage the higher real nominal yields we talked about.
Chris Hyzy
On an average basis.
Matthew Diczok
On an average basis. If we're talking more about a client, more total return focused, when we talk that they're probably going to want to be, slightly overweight equities. Then they're going to figure out their advisor, where should they be in fixed income. Should they be close to treated duration? Should they take a little more credit risk? That's that more the conversation.
Finally, if you have an investor who has cash needs coming up near-term or is really risk averse, well then they're going to want to shorten the mature of their bond portfolio, but they're going to want to do away that balance is, a prudent, uh, duration, as well as some additional yield. And trying to find a way to enhance yield in a relatively conservative way would make sense for an investor in that situation.
Chris Hyzy
Thanks, Matt. Thanks for joining me today.
Matthew Diczok
Happy to be here, Chris. Thank you.
Chris Hyzy
I hope you found this program informative and useful as you consider your portfolio decisions in 2025. Bond yields are subject to continual change and we'll keep you posted as events unfold in the weeks and months to come.
Periodic volatility is likely, so stay diversified, stick to your long-term strategy and avoid making sudden changes based on market predictions. Your advisor can work with you to help you ensure your portfolio is properly balanced to pursue your long-term goals. Thanks again.
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[End of transcript]
The normalization of the yield curve — with long-term bonds paying more than short-term bonds — was considered a key event to look out for in 2025. As it turned out, in the first few weeks of this year the surge of 10-year Treasury yields has proven to be a big story.
"Bond yields don't always dominate the headlines, but they're now capturing attention for what they say about a strong economy, inflation and the likely path of Federal Reserve interest rate cuts," says Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank.
In this video, Hyzy and Matthew Diczok, head of Fixed Income Strategy for the Chief Investment Office (CIO), Merrill and Bank of America Private Bank, discuss the yield story and what it means for investors.