After the Federal Reserve’s (Fed) most aggressive rate hiking campaign in decades, short-term interest rates are at levels last seen in the early 2000s. Moreover, due to the elevated fed funds rate and the subsequent carryover into the U.S. Treasury market, the Treasury yield curve is the most inverted (shorter-term Treasury securities out yielding longer-maturity securities) since the early 1980s. Investors are now, finally, allowed to generate a return on cash.
However, the Fed’s goal has been to take the fed funds rate into restrictive territory to make the cost of capital sufficiently expensive to slow aggregate demand, which should reduce inflationary pressures. Then what? After winning its fight with inflation or in response to a recession, markets expect the Fed to start reducing rates as early as this year. After keeping rates at these levels, the Fed will then likely take the fed funds rate back to a more neutral level, which economists believe is 2.5%, or even lower. Just as the aggressive rate hiking cycle took Treasury yields higher, interest rate cuts should take Treasury (and other bond market) yields lower, and that is when the reinvestment risks will show up. And since inflationary pressures are easing, and as cracks appear in the regional banking sector, it is likely the Fed may be done with its rate hiking campaign, which would be welcome news for core bonds.
In fact, if the Fed is indeed done raising interest rates, we could start to see lower yields on intermediate-term securities before the Fed does cut rates. Of the most recent Fed rate hiking campaigns, 10-year Treasury yields were lower, on average, by 1% a year after the Fed stopped raising rates, which could mean strong positive returns for core bonds.
There is a risk that inflationary pressures will remain high, and that the Fed has to continue its rate hiking campaign into a weakening economy. Should interest rates increase by another 1% from current levels, fixed income markets broadly could still generate slightly positive returns over the next 12 months.
The technical setup for Treasuries suggests high watermarks for yields have likely been reached. Since core consumer inflation in the U.S. peaked last fall, 10-year yields have registered a string of lower highs that together form a developing downtrend. The recent bearish crossover of the 10-year yield’s 50-day moving average below the 200-day moving average adds to the evidence of a potential downtrend in the making.
For reference, moving averages represent the average yield across a select number of trading days and are used to identify trend direction. The key word here is “potential,” as yields have not registered consecutive lower lows, a major piece of missing evidence to confirm a new downtrend is officially underway.
If we do 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%, respectively, after the Fed stopped raising rates. Moreover, all periods generated positive returns over the 6- month, 1-year, and 3-year horizons.
While cash is a legitimate asset class again, it is all about balancing today’s opportunity with what may or may not be available tomorrow. 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, 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- 05371067.
- 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.
- The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.