Bond Yields Are Headed Lower. The Path May Be Bumpy.

About the author: Patti Domm is an Emmy Award—winning financial journalist.

The highest bond yields of the year could be behind us, leaving the direction of U.S. interest rates on a mostly lower path for the second half of the year.

Yet it may not be a smooth and easy glide lower, and it may be a bad news is good news scenario that drives the bond market.

The benchmark 10-year closed at a high of 4.7% on April 25. Since then it’s down nearly half a point to 4.24 today.

Investors have been myopically focused all year on the Federal Reserve’s interest rate policy and whether and when it will cut rates. Mixed messages from a procession of Fed speakers have only made the market more tense.

Now with a cut almost assured for the final months of the year, the market will remain on high alert around Fed speakers, but it should widen its field of vision to focus more broadly on geopolitical factors. That would include the U.S. presidential election and other high-profile votes elsewhere. If the election or any other event unsettles markets, that could be a positive for bond prices and push yields lower. The same is true should the economy begin to weaken and the unemployment rate start creeping up.

Lower yields are normally good news for stock market investors and home buyers, who have watched the gyrations in the 10-year with trepidation since it influences mortgages and other loans. The stock market has taken the higher yields in stride, hitting new records, while supported by earnings, the economy, and optimism about artificial intelligence.

But the stock market itself could become a factor that drives yields lower. Historically, stocks have done well during the summer ahead of a presidential election. That could be the case again this year. But equities could hit some bumps as the election approaches on Nov. 5.

“I feel like basically the best is behind us, and we priced in a lot of this good news,” said George Goncalves, MUFG head of U.S. macro strategy. “What could be the shock? It could be something from left field. It’s hard to place what will be the catalyst. We know valuations are stretched…That’s even true for bond markets.”

The Fed has been targeting a short-term rate of 5.25-5.5% since it stopped raising rates in July. Goncalves said investors have fought the Fed, pricing in lower yields than the central bank’s target rate range would suggest. “The 10-year is over 100 basis points below the Fed funds. We’ve never believed the Fed was going to stay higher for longer,” he said. In fact, earlier this year, bond markets were looking for as many as six rate cuts this year.

A quarter-point reduction now appears to be coming by December, and the market is pricing in a strong chance that it will come before that—in September. Tamer inflation readings and interest rate cuts by global central banks have given traders some assurance that the Fed will soon make a move to cut at least once this year.

“We’ve shifted into a different environment globally,” said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. The rate cuts already made by the Bank of Canada, European Central Bank, and Swiss National Bank have set global rates on a downward slide, and the U.S. will ultimately follow.

The Swiss National Bank has been leading the way, already cutting rates for a second time last week. In its statement, the central bank pointed to improved inflation but also warned that “geopolitical tensions” could slow economic activity around the world and that inflation could stay high in some countries.

“It’s not unheard of for such a policy divergence between the U.S. and the rest of the world, but it doesn’t persist indefinitely,” said Lyngen. “Eventually the Fed is going to begin the process of lowering rates.” He added that expectation has capped how high yields will go in the current environment.

He said he expects lower yields, but the 10-year yield may test its 200-day moving average, which would be 4.35%. It could “even push back to 4.50%, but we’re not going to get 4.75%,” he said.

Other strategists see a range from the upper 3% area back to that 4.7% high or slightly above.

A major wildcard could be the U.S. presidential election, but Lyngen said the outcome in November may only disturb the bond market if one party or other sweeps Congress and the White House. That could result in less fiscal discipline either way.

But traders will be watching closely and are wary that markets could price a very negative outcome if the election results are very close or undetermined, opening the door to a contested election. When the winner is known, crucial pieces of the U.S. economic outlook will be more clear, like the direction of foreign policy, fiscal policy, trade tariffs, and taxes.

Even before the U.S. goes to the polls, there are snap elections in France June 30 and July 7. They will determine whether President Emmanuel Macron’s centrist party retains control of the government. The uncertainty has already been a factor in the market and has the potential to drive U.S. yields lower in a flight-to-safety trade.

The spread between French bond yields and the EU benchmark German bunds widened significantly but have since narrowed.

Jim Caron, chief investment officer, Portfolio Solutions Group at Morgan Stanley Investment Management, said he believes the French markets initially overreacted. But investors will be watching.

Investors worry a loss by Macron will have bigger implications for euro zone policies.

“It’s going to make a lot of headlines. I think there’s going to be a period at the end of June, beginning of July between the elections that people get nervous but I’m not overly concerned,” said Caron.

The U.K. also holds its election July 4, and markets will watch that too. Polls point to a Labour Party majority, ending more than a decade of Conservative party rule. So far, markets are taking this election in stride and that may be in part because Labour is showing signs of leaning more to the center fiscally.

Clearly, bond investors globally care about leaders being responsible about spending and deficits. In the U.S., whether President Joe Biden is re-elected or former President Donald Trump returns to the White House, Caron said the market will judge them on similar grounds.

“They’re both going to spend until the market forces them not to. That’s the typical trend,” he said.

For now, the bond market is expecting an economic soft-landing and lower rates. As long as the Fed does not veer from its expected course, yields could stay in the current range. But investors need to watch for the unexpected this summer, whether from tensions in the Middle East, Ukraine or a higher than expected degree of friction around the U.S. election. That still most likely means the direction for yields would be down, not up.

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