Bond investors have more reasons for optimism as we enter a phase where the yield curve is normalizing, monetary policy is likely to loosen and the market’s risk appetite is diminishing. Recent Morningstar fund flow data highlights this shift, with taxable bond inflows accounting for 87% of all US Fund and ETF flows for the first half of 2024.1 However, we think the rotation into the active intermediate category has much more room to grow as trillions of dollars remain on the sidelines in money market and other short duration vehicles.
While several factors are driving this shift—including the flattening yield curve discussed below—it is notable that falling inflation may no longer be the primary catalyst of fixed income returns. Instead, the following factors are emerging as the new tailwinds for fixed income:
- Rising Unemployment: The unemployment rate is currently above the Federal Reserve’s year-end prediction (4.3% vs. 4.0%), with other key labor metrics such as job openings and job creation trending down. This weakening in the labor market may lead to reduced consumer spending and slower economic growth.
- Policy Signals: There are indications of pre-emptive rate cuts this year in an effort to achieve a soft landing, reminiscent of Alan Greenspan’s approach. While the inflation dragon has not been slain, it is in a better place with the focus now being on sustainable growth.
- Negative Bond-Stock Correlations: Amid currency-related deleveraging and an apparent equity rotation, bond-stock correlations have turned negative. In other words, bonds may be a more reliable hedge going forward in the traditional 60/40 portfolio.
Heading for a Recession? Or are we Already There?
While the possibility of a recession in the second half of the year remains uncertain, it’s crucial to remember that official recessions are often recognized many months after they begin. What we can observe now, however, is the yield curve’s ongoing normalization. This shift from an inverted yield curve—where short-term rates exceed long-term rates—to a more typical positively sloped curve, is critical. It carries significant implications for fixed income flows and investors, as it often signals positive returns for the core bond market.
The chart below illustrates the Bloomberg US Aggregate Bond Index’s performance six months before and after the onset of an official recession. An additional line shows the Index performance assuming an official recession were called 08/09/2024.
These historical results were obtained in different economic scenarios and interest rate environments, but they highlight the positive impact of yield curve transitions on Core bonds as represented by the Index.
Conclusion
Bonds have regained their rightful place in an asset allocation. While there are compelling reasons to be constructive, significant risks unique to this cycle remain, and these risks need to be actively managed—a topic we will continue to address in future writings. Volatility is a natural part of risk regime changes and we may be undergoing one at this moment that is much more constructive for bonds than the past few years.
Important Disclosures & Definitions
1 Morningstar US Fund Flows report, June 2024
Bloomberg US Aggregate Bond Index: a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, fixed-rate agency MBS, ABS and CMBS (agency and non-agency). One may not invest directly in an index.
AAI000740 08/20/2025
