Investors may be overlooking a significant shift in fiscal policy that could benefit long-term bonds and rate-sensitive sectors. According to Bank of America’s chief investment strategist, Michael Hartnett, the potential for tighter government spending and stabilizing yields presents an attractive opportunity for bond investors. Over the past two years, fixed-income assets have struggled due to rising interest rates and higher deficits. However, Hartnett believes that the tide is turning, with yields approaching peak levels and a more cautious stance from the Federal Reserve. He also highlights the historical performance of U.S. Treasuries, which have never had negative 10-year returns over the past nine decades.
The Turning Tide in Bond Markets
Hartnett argues that the recent surge in yields has created a favorable environment for bond investments. Corporate bonds now offer competitive yields, making them attractive to pension funds and other institutional investors. He recommends focusing on long-duration bonds, particularly those tracked by the iShares 20+ Year Treasury Bond ETF (TLT). The slowing of U.S. government spending and the Federal Reserve's cautious approach to inflation are key factors supporting this view. If yields retreat toward 4%, diversified low-risk bond portfolios could generate annualized returns of 11%-12%. Higher-risk allocations might yield up to 15%.
Historically, U.S. Treasuries have shown resilience, with no negative rolling 10-year returns in the past 90 years. The technical indicators also suggest stability, as the 30-year Treasury yield has hit a double top at 5%, indicating strong resistance. Hartnett believes that if yields drop 100 basis points, the bond market could see strong returns, even if yields rise modestly. With current yields near 5%, the worst may be over for bonds, presenting a "very good" risk-reward profile.
Fiscal Policy Shift Under Trump
Hartnett points out that the U.S. budget deficit has risen sharply, reaching $7.3 trillion, significantly boosting nominal GDP. Government spending has been a major driver of economic growth. However, with the Federal Reserve prioritizing inflation control and the likelihood of Donald Trump pushing for spending cuts, deficits could shrink, reducing upward pressure on yields. This scenario could lead to what Hartnett calls the "twin peak" in 5% bond yields. Scott Bessent, Trump's nominee for Treasury Secretary, emphasized during his Senate confirmation hearing that addressing government spending will be a top priority. He highlighted runaway spending as a key reason for joining the Trump campaign, signaling a commitment to aggressive fiscal tightening.
Bessent’s focus on reducing government outlays aligns with a broader shift toward fiscal discipline. This change could stabilize or even lower yields, benefiting long-term bondholders. Investors looking to capitalize on this trend should consider rate-sensitive exchange-traded funds (ETFs) such as the SPDR S&P Homebuilders ETF (XHB), Utilities Select Sector SPDR Fund (XLU), Financial Select Sector SPDR Fund (XLF), and SPDR S&P Biotech ETF (XBI). These sectors stand to gain from lower mortgage rates, defensive dividend-paying stocks, a steepening yield curve, and reduced borrowing costs, respectively.
A significant legal milestone is approaching for Mozambique as its former finance minister, Manuel Chang, prepares to be sentenced in a New York court on charges of wire fraud and money laundering. The case, rooted in the controversial "tuna bond" affair, has had far-reaching consequences for the impoverished African nation. Prosecutors allege that Chang accepted bribes to secretly commit his country to approximately $2 billion in loans from international banks. These funds were intended for maritime projects but were misappropriated by officials and bankers. Chang, who served as the country's top financial officer from 2005 to 2015, could face up to two decades in prison. His defense team argues he should only serve the time already spent in custody. This case highlights the severe impact of corruption on developing economies.
The saga began when Mozambique's government, through three state-controlled entities, borrowed substantial sums between 2013 and 2016. Ostensibly, these loans were meant to fund a tuna fishing fleet, shipyard development, Coast Guard vessels, and other maritime initiatives. However, prosecutors claim that instead of benefiting the nation, the funds were diverted into private accounts through a web of bribes and kickbacks. Chang himself is accused of receiving $7 million in illicit payments. The mismanagement of these funds not only defrauded investors but also plunged Mozambique into a severe financial crisis. When the hidden debt was exposed in 2016, it amounted to roughly 12% of the country's GDP at the time.
Chang's arrest in Johannesburg in 2018 marked a turning point in the case. After a prolonged extradition battle, he was brought to the United States in 2023 to face charges. During the trial, prosecutors presented evidence of how the loan proceeds were misrepresented, leading to significant losses for investors. Chang's defense argued that there was no direct quid pro quo and that he was merely following orders from his government. Despite this, the conviction stands, and now the focus shifts to sentencing. Prosecutors recommend an 11 to 14-year sentence, while Chang's lawyers argue for his immediate release based on time already served.
The repercussions of the scandal have been profound. Mozambique's economy suffered greatly, with nearly two million people falling into poverty. Government services were cut, economic growth stagnated, inflation skyrocketed, and the currency plummeted. International investment and aid also dwindled. Meanwhile, efforts to negotiate with creditors continue, and several individuals have been convicted in Mozambican courts over the scandal, including the son of the former president, Armando Guebuza. As Chang faces his sentence, the case underscores the devastating impact of corruption on vulnerable economies and the importance of transparency in public finances.
This week witnessed a significant shift in the financial markets as both stocks and bonds experienced a remarkable turnaround. After enduring prolonged periods of sell-offs, investor sentiment has been revitalized by a series of events that suggest the Federal Reserve may adopt a more accommodative monetary policy stance. The S&P 500 is set to achieve its best weekly gain since November 2016, with the Dow and Nasdaq also showing substantial increases. Concurrently, bond yields have dropped, indicating a recalibration of expectations regarding future rate cuts. This reversal reflects growing confidence among investors that the Fed will implement more easing measures than anticipated.
The resurgence in market performance can be attributed to several key developments. First, the release of December's inflation report revealed that core inflation, excluding volatile food and energy prices, was slightly lower than expected. This data point alleviated concerns about runaway inflation and signaled to traders that the economy might not be overheating. Consequently, the 10-year Treasury yield fell sharply, reflecting increased demand for bonds.
Further bolstering this optimistic outlook was Thursday's retail sales report, which showed a modest increase but missed forecasts. While this weaker-than-expected data might typically cause concern, it was viewed positively by investors as it suggested the economy had cooled enough to provide the Fed with greater flexibility in its monetary policy decisions. A slower economic pace could reduce pressure on the central bank to raise rates, thereby supporting the case for potential rate cuts.
A pivotal moment came when Christopher Waller, a prominent Fed official, shared his views on CNBC. He indicated that if inflation continued to improve, the Fed might consider implementing rate cuts earlier than previously thought. Waller even mentioned the possibility of up to three or four quarter-point reductions if the data supported such actions. His comments reinforced the market's belief in a dovish Fed approach, leading to a surge in stock prices and a decline in bond yields.
The market's response to these developments highlights a growing consensus that the Fed will pursue a more aggressive easing cycle. Investors are now placing higher odds on multiple rate cuts occurring sooner rather than later. The probability of three or more rate cuts has risen significantly, reflecting a shift in market expectations from just a week ago. This renewed optimism has injected fresh momentum into both equity and bond markets, setting the stage for continued positive performance in the coming weeks.