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In late April, long-term Treasuries started bullish rally that looked like it had some legs. Beaten down by rising interest rates, it appeared as if the catalysts were coming together to turn this asset class around.

The launch of the Fed’s rate cutting cycle was imminent and bond traders began buying in anticipation of it. Inflation had come down to within range of the Fed’s 2% target, easing some of the pressure on the Fed’s restrictive policy stance. Plus, even though the closely watched data was signaling a U.S. economy still in pretty good shape, credit conditions - in particular, delinquency and default rates on both the consumer and commercial sides - were indicating that support for current growth expectations might be overstated.

That was my position earlier this year when bonds started to rally, but even in June when I talked about what the bond rally could look like, I acknowledged that this might just be a shift in the yield curve as opposed to a genuine flight to safety pulse.

As we look back now over the past six months, it sure looks like it was just a shift in the yield curve.

Even though gold was rallying, there wasn’t much indication that there was a flight to safety built into it. Long bond yields dropped, but so did other yields along the curve at a roughly commensurate rate. The iShares 20+ Year Treasury Bond ETF (TLT) rose more than 17% from its late April, but it was mostly a duration-related move. Credit spreads barely moved outside of the short-term spike in August when the yen carry trade was unwinding.

Now, long end yields are back on the rise and Treasury bonds are losing ground again.

From its mid-September low, the 10-year Treasury yield is up about 60 basis points. This is an historical anomaly based on how yields usually react around Fed rate cuts. Typically, yields trend slightly lower or sideways after the first cut with most of the gains in the bond market coming in the 3-4 months prior. We got the gains in the lead-up as history has suggested, but subsequent spike in yields afterwards suggests something is different this time around.

I think a big part of the reason for this is that rate cuts typically coincide with a slowing economy. Rates tend to trend lower post-first rate cut because investors see things slowing and prefer the safety of bonds.

In 2024, however, we’ve got a different backdrop - the Fed is cutting rates into a healthy economy, not a deteriorating one. That means can somewhat throw history out the window. The traditional path of returns, which generally sees bonds delivering steady gains once the Fed starts lowering rates, may not be valid this time around.

So why are bond yields starting to move higher this time around instead of lower? I think there are two things going on.

Unwinding Previous Safe Haven Trades

From late April through the middle of September, we saw a steady drop in long-term Treasury yields (along with yields all along the rest of the curve). As mentioned earlier, I don’t believe this was a flight to safety trade; just a broad adjustment to the yield curve. The stock/bond correlation remained positive throughout this period and high yield spreads didn’t meaningfully rise. You’d expect a negative correlation and rising spreads in more of a flight to safety environment.

But Treasury bond buying did certainly happen over this period and that resulted in increased fixed income allocations in many portfolios.

Now that rate cuts have begun, a reassessment of economic conditions, including GDP growth, corporate earnings, unemployment and inflation, show that 1) things are still in pretty good shape and 2) there’s no real signal that this might change anytime soon. The Atlanta Fed’s GDPNow forecast calls for a Q3 growth rate of more than 3%. The latest non-farm payroll data shows jobs still being added to the economy at a reasonable pace. The headline inflation rate is creeping ever closer to the Fed’s 2% target, although core, rent and services inflation rates are still elevated. Corporate earnings relative to expectations has been positive in Q3 thus far and future quarters are expected to see the return of double digit annualized growth.

That kind of Goldilocks backdrop coupled with the Fed lowering interest rates has investors in a very risk-on mood. In the eyes of many, there’s no more reason to hold on to those safe haven hedges, so they’re selling off those bond positions and returning to risk assets, such as stocks.

Inflation Risk Is Growing Again

This is, in my opinion, one of the more unappreciated parts of the soft/no landing narrative. Healthy economic growth combined with easing monetary conditions generally leads to rising price pressures. It’s easy to overlook that today given that inflation rates are still trending lower, but a lot of the catalysts are in place right now that could reverse that trend pretty quickly.

If growth rates and corporate earnings growth rates remain on pace as currently forecasted, the Fed keeps cutting rates and the government keeps adding further liquidity to the system, which is largely expected in Q4, it’s a recipe for the return of inflation. Maybe not to the levels we saw in 2021 and 2022, but certainly much higher than the Fed’s target. Then rate cut expectations turn into rate hike expectations and yields head higher.

The fact that gold has been this strong for this long indicates that some degree of inflation concern is getting priced in right now. TIPS have been steadily outperforming the broader Treasury market, which also happened in the lead-up to the hyper-inflationary environment of a few years ago. And now we’ve got long-term yields moving sharply higher.

The inflation problem is far from solved in the U.S. even where we stand right at this moment. It’s not difficult to envision a scenario in which it gets worse from here.

Conclusion

I would suggest that investors remain on alert here and continue closely watching the trends with gold, Treasury yields and TIPS. All three of these asset classes (you could utilities on the equity side as another sector to watch, which is the best-performing sector year-to-date) are reacting in a way that’s consistent with rising inflation risk. I wouldn’t be surprised if these trends continue for a while.

It’s not tough to see that the bulls are in control right now and not surprising to see that there’s little interest in bonds at the moment. While current enthusiasm levels might be a little overdone, I don’t see a short-term sentiment reversal that fuels a big push back into bonds.

The current move higher in long-term yields may have further to go.