The Fed met last week and, as expected, raised short-term interest rates. With inflationary pressures trending in the right direction and still no signs of a wage/price spiral, which could reignite inflationary pressures, the Fed may be close to ending its rate hiking campaign.
Once the Fed has finished raising interest rates, we could start to see lower yields on intermediate-term securities before the Fed actually cuts rates. Just as the aggressive rate hiking cycle took Treasury yields higher, interest rate cuts will take Treasury (and other bond market) yields lower. After recent Fed rate hiking campaigns, 10-year Treasury yields were lower, on average, by 1% a year after the Fed stopped raising rates. And while the base case remains a trading range for the 10-year yield between 3.25% and 3.75% throughout 2023 (similar to the 2006 Fed rate hiking campaign, when the Fed kept rates at elevated levels for over a year), there is a potential for yields to end the year somewhat lower, which would mean strong positive returns for core bonds.
There is also the potential that inflationary pressures remain high, and that the Fed has to continue its rate hiking campaign into a weakening economy. Should the Fed take the fed funds rate to 6%, we could see the 10-year around 4.75%. However, given where starting yields are, if interest rates increase by another 1% from current levels, fixed income markets broadly could all still generate slightly positive returns over the next 12 months.
Treasury yields have been relatively volatile over the last several weeks as speculation intensifies over the Fed’s next monetary policy moves. Signs of labor market strength in the June ADP report drove rate hike expectations higher and two-year Treasury yields back to their March highs at 5.08%. However, from a technical point of view, yields failed at this key resistance level after the nonfarm payrolls report showed that hiring decelerated in June. The message from the failed breakout and subsequent pullback in two-year yields suggests the Fed could be done raising rates after this week’s 0.25% rate hike. Of course, the message from the market is subject to change, and if the Fed does lean more hawkish than expected, watch for resistance at 5.08%, as a breakout above this level would point to more rate hikes on the horizon.
The technical setup for 10-year Treasury yields suggests the high watermark for this rate hike cycle was set in October. Since then, a developing downtrend has emerged as yields registered a series of lower highs. While the jump in interest rates earlier this month briefly challenged this downtrend, resistance at the March highs contained the upside momentum. Yields have since pulled back and are now hovering above their 200-day moving average. (For reference, moving averages represent the average yield across a select number of trading days and are used to identify trend direction.) A break below support at the 200-day moving average near 3.70% would leave 3.25% as the next major area of downside support. This level not only marks the April lows for the 10-year, but it also traces back to the 2018 highs, a major breakout point from a multi-year bottom formation. Furthermore, support at 3.25% has prevented yields from registering consecutive lower lows, a major piece of missing evidence to confirm a new downtrend is officially underway. Given the significance of the 3.25% support level and the limited upside risk for yields based on both technical and macro factors, 10-year yields may remain bound in the 3.25% to 3.75% range until a confirmed trend develops.
Should we see lower yields over the next year, intermediate core bonds could very well outperform cash and other shorter maturity fixed income strategies. Historically, core bonds, as proxied by the Bloomberg Aggregate Bond Index, have performed well during Fed rate hike pauses. Since 1984, core bonds were able to generate average 6-month and 1-year returns of 8% and 13% (annualized), respectively, after the Fed stopped raising rates. Moreover, all periods generated positive returns over the 6-month, 1-year, and 3-year horizons.
But, even if rates don’t fall from current levels, fixed income is as attractive as it has been in over a decade. There are three primary reasons to own fixed income: diversification, liquidity, and income. Right now, investors can build a high-quality fixed income portfolio of U.S. Treasury securities, AAA-rated Agency mortgage-backed securities (MBS), and short maturity investment grade corporates that can yield 5-6% and will do well if rates fall and provide steady income if rates stay at current levels. Moreover, until rates do eventually fall, you get paid to hold fixed income from the coupon payment. And, the longer rates stay at these elevated levels, the more enduring fixed income is as an asset class, which is good news for income-oriented investors. Investors do not have to “reach for yield” anymore and take on a lot of risk to meet their income needs.
So, unless investors have short-term income needs, they may be better served by reducing some of their excess cash holdings and by extending the maturity profile of their fixed income portfolio to lock in these higher yields for longer. Bond funds and ETFs that track the Bloomberg Aggregate Index, along with separately managed accounts and laddered portfolios, all represent attractive options that will allow investors to take advantage of these higher rates before they are gone.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
Data provided by Bloomberg, FactSet, and LPL Financial, tracking # 1-05375923.
- US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity.
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