A year ago, most economists got it wrong: they predicted the U.S. economy was headed for a recession by the end of 2023. Bond returns also flipped from deep losses in 2022 to a positive year in 2023, with the Bloomberg U.S. Aggregate Index returning 6.82% in the fourth quarter alone. As 2024 begins, growth remains robust with the S&P 500® index hitting new highs and soft landing predictions abound.

But where does the economy go from here? Will economic expansion persist? Or will the aggressive interest rate hikes by the Federal Reserve to cull inflation, or some unknown shock, conjure that recession after all? Investors face a wide spectrum of possible outcomes for growth over the next few years. We believe investors – especially those who moved to cash when inflation was soaring – can benefit by investing in bonds. But what’s the right sector when the path is not clear? 

2023 has delivered some bright spots. Economic growth, represented by real gross domestic product (GDP) grew steadily throughout the year, with an especially robust showing in the third quarter of 4.9% and an “advance” estimate of 3.3% for the fourth quarter. One trend that appears strong is the decline in inflation, with the Consumer Price Index (CPI) falling from a very high 9.1% in June 2022 to 3.4% in December 2023. Unemployment in 2023 was persistently low and fairly range-bound below 4%. January started at 3.4%, reaching an October high of 3.9% before retreating to 3.7% in both November and December. The inflation and unemployment rates are on a trajectory to achieve the Fed’s twin goals of maximum employment and 2% inflation rate.

As inflation’s decline appears to be a sustained trend, markets have begun pricing in Fed rate cuts for 2024. The Fed’s December 2023 economic projections also indicated rate cuts in 2024. Due to falling inflation, these cuts appear plausible even if the economy doesn’t enter recession. If inflation slides down to the Fed’s 2% target, that will likely require several maintenance rate cuts to keep the “real” policy rate (which subtracts the rate of inflation from the nominal rate) steady.

However, even among these positive economic indicators, caution is advisable. The effect of monetary policy, such as the Fed’s actions, typically lags market reaction. And a world of political unrest and unpredictability, including the upcoming U.S. presidential election, could cause markets to stumble. And a recession would serve as a headwind to credit sector returns. All of these elements could force the Fed to make deeper rate cuts than originally anticipated.

That stated, as inflation continues to fall, we believe fixed income sectors will look attractive in many possible economic scenarios.  We have outlined a few scenarios and where to consider investing in bonds accordingly.

Anticipate a recession? Look to core and municipal bonds

As financial conditions continue to tighten and fiscal stimulus wanes, growth could begin to weaken. If the U.S. economy starts to contract and unemployment rises amid mostly tamed inflation, the U.S. Federal Reserve (Fed) is likely to respond with rate cuts.

In the recessions since 1981, the Fed has responded by ultimately cutting at least 100% of the interest hikes that occurred in the previous cycle. Current pricing accounts for less than 30% of this cycle’s 525 basis points of hikes that could be cut. That leaves a lot of potential upside for bond prices to rise amid recession.

Put another way, the same forces responsible for deep losses when the Fed raised interest rates would have a compelling reason to do the opposite – cut rates and boost bond markets – if the economy hits a rough patch. The impact of declining yields on a bond or bond fund is dependent upon its duration – a measure of its interest rate sensitivity. The higher the duration, the more impact changing yields have on a bond or bond fund's price. Some intermediate core, core-plus and municipal bond funds could see a notable lift through their duration as yields decline. The following table illustrates the relationship of yield and duration on bonds.

Core and core-plus bond mutual funds and bond exchange-traded funds (ETFs) are available to investors who seek solid yield and moderate duration for potential upside when rates fall, both of which could provide a tailwind to returns. For investors in higher tax brackets seeking an additional income boost, municipal bonds provide income exempt from federal taxes, as well as sometimes state and local taxes.

Read important investment disclosures

Think growth will remain strong? Consider credit.

Despite the Fed’s efforts to tighten, the labor market has not weakened materially and corporate earnings have been solid — even amid falling inflation. The result? Credit has thrived. As long as the economy continues to hum, that could continue, with higher income-driven bonds continuing to provide strong yields relative to the past 10 years.

At these recent yield levels, higher income sectors have had strong returns historically. 

For investors anticipating a growth environment, they may want investments positioned to seek higher yields. To potentially boost income further, the tax-exempt nature of municipal bonds may be worthy of consideration.

Of course, today’s strong relative yields have the potential to provide a strong foundation for the total return of these credit sectors. Even if the economy weakens and credit spreads (the premium investors earn for credit risk over Treasuries) widen, those solid starting yields could provide cushion against resulting price losses to help keep total returns positive.

Expect “more of the same”? Explore short-term bonds.

When bond yields were rising, holding certificates of deposit (CDs) may have limited losses bonds faced due to resulting price volatility. Even if interest rates remain relatively high for longer and the Fed remains on pause before cutting rates for longer than markets expect, bond prices could provide an incremental boost to total returns if bond yields begin to drift down. That’s exactly what we’ve seen historically over the past four cycles, as the two-year Treasury yield demonstrates. In fact, that yield may already be declining from a peak in October 2023.

But luckily, it’s not too late. Even if investors move to short-term bonds from cash as a first step to get back into the market while seeking to limit interest rate risk, they can see upside potential. Short-term bond yields remained high on a historical basis, peaking at 5.22%, and some of these short-term bond funds also prioritize capital preservation – seeking to limit credit risk. Although their lower duration also provides less upside if yields begin to fall, these shorter term options could still feel a tailwind to returns in that scenario relative to cash, which has no interest rate exposure. Investors should also consider that the return of principal for bond investments is not guaranteed, whereas cash deposits are generally FDIC-insured. 

Bottom line

We believe investors can be prepared for a variety of scenarios, even amid an uncertain outlook. Of all the trends in today’s market, the decline in inflation and the Fed’s pivot away from interest rate hikes seem among the clearest to us. While investors feeling confident on their view of the economy’s path may choose one of the three strategies suggested here, a diversified bond allocation could be employed to help hedge against whatever market scenario comes next.