Almost all factors are "favorable," and the U.S. bond market is expected to deliver its "best performance" since 2020.

The U.S. bond market is experiencing its best year since 2020, as multiple positive factors including Federal Reserve rate cuts, a moderate economic slowdown, and continuously easing inflationary pressures combine to drive an across-the-board rally.

According to media reports on Monday, the Bloomberg U.S. Aggregate Bond Index has returned about 6.7% so far this year, accounting for price changes and interest payments, and is on track for its best annual performance since 2020. This surge has finally delivered returns to bond investors who suffered a historic setback in 2022.

The Federal Reserve has cut interest rates twice this year and may cut further. Although job growth and consumer spending have slowed, there are still no signs of an economic recession that could threaten corporate balance sheets. Although the market is concerned that Trump’s tariff policies could push up prices, inflationary pressure continues to ease.

Unlike previous years, this year the return of the U.S. bond index has easily surpassed that of short-term Treasury bills, another major choice for investors seeking safe alternatives outside the stock market.

Rate Cut Expectations Overwhelm Deficit Concerns

The Fed’s rate cuts have become the core driver behind the bond market rally. Bonds issued when rates were high become more valuable when the market expects rates to drop. At the beginning of the year, investors were unsure whether the Fed could cut rates amid sustained inflation and Trump’s possible expansionary fiscal policies. But the cooling labor market has prompted two rate cuts so far, with more possible.

U.S. Treasury yields have declined accordingly. The 10-year U.S. Treasury yield has fallen nearly 0.5 percentage points this year, closing at 4.149% last Friday.

Earlier this year, there was a brief but sharp sell-off in the U.S. Treasury market, causing concerns that the market might eventually be unable to bear the pressure of massive U.S. borrowing. The size of the budget deficit affects yields, as larger deficits mean the government needs to borrow more by issuing Treasuries, which in turn requires higher rates to attract demand. But rate cuts have basically outweighed all these concerns.

Trump Administration Closely Monitors Bond Market

The Trump administration keeps a close eye on the bond market and has intervened multiple times during periods of volatility. In April, President Trump paused most of his so-called reciprocal tariffs due to bond investors being “nervous.” Treasury Secretary Besant said keeping long-term Treasury yields low is a government priority, as these yields are benchmarks for various loan costs from mortgages to student loans.

Though government and corporate bond yields are gradually declining, they remain well above the depressed levels of most of the past decade, leading investors to hope to lock in these yields.

Cal Spranger, fixed income fund manager at Badgley Phelps Wealth Managers, said, "As a bond fund manager, client meetings have become much more interesting this year—years ago, I didn't get invited at all."

Multiple Risks Still Threaten the Rally

Despite the optimistic outlook, the bond market rebound still faces many threats.

The path of rate cuts has become hazy due to disagreements among Fed officials, with some pouring cold water on the possibility of a rate cut in December. In October, Fed Chair Powell warned that the Fed is "far" from deciding on next month’s rate cut, an unusually frank statement for a central bank official.

Investors currently see about a 50% chance of a rate cut in December. CME Fedwatch tool data shows futures markets last Friday priced in about a 46% chance of a rate cut, down from around 67% a week earlier.

Some are concerned that the U.S. corporate bond market is overheated, with valuations at historic highs potentially masking excessive market behavior and failing to adequately compensate investors for the risks taken. The excess yield, or spread, on investment-grade corporate bonds over Treasuries fell to 0.72 percentage points in September, the lowest since the late 1990s, before rebounding slightly to 0.83 percentage points.

Some analysts warn that the U.S. government’s budget deficit could again weigh on the bond market. The deficit for fiscal 2025 is $1.8 trillion, virtually unchanged from 2024. "This is definitely going to be a problem at some point," said Mike Goosay, Chief Investment Officer and Global Head of Fixed Income at Principal Asset Management. "You can only borrow so much before investors start to walk away."

However, many investors believe the good times will continue, confident that despite recent rising uncertainty, there is still room for rates to fall further. Matt Brill, Senior Portfolio Manager and North American Investment Grade Credit Chief at Invesco, says his team favors short-term bonds, believing upcoming economic data will push the Fed to keep cutting rates. “While there haven’t been mass layoffs, there also haven’t been any new jobs created,” he said, “I think the Fed is paying attention to this, and it worries them.”

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