by Blaine Dickason
Senior Vice President
Trading and Fixed Income Portfolio Management
Paul Volcker assumed the chairmanship of the Federal Reserve in August of 1979 and within a year, had raised the target federal funds rate to an eye-popping 20%. This painful but necessary action broke the back of inflation which had run rampant for the prior decade. It also sowed the seeds for a bull market in bonds for the subsequent 40 years, over which time the benchmark U.S. Aggregate Bond Index produced an annualized return of 7.8%*! It was a golden period for bond investors.
This 40-year bond bull market was not without interruption as, on occasion, shorter periods of rising interest rates drove bond prices down temporarily. Since 1980, there have been six instances where the yield on the benchmark 10-year U.S. Treasury has increased more than two percentage points, including the most recent change from 0.50% to in August 2020 to 3.2% last month. Given that we’ve already seen an “average” move in yields from the recent lows, it’s natural to examine whether we believe yields have peaked, as that can have major implications for asset allocation in client accounts.
The Federal Reserve uses the federal funds interest rate as their primary policy tool. However over the last six months, they have prepared markets for upcoming rate hikes through extensive communication in what’s known as ”forward guidance”. They have signaled one-half percent rate hikes over each of the next two Federal Open Market Committee meetings in mid-June and late-July, and more importantly, markets have already priced this into current yields. Total rate hikes this cycle are expected to deliver a terminal Fed Funds rate of around 3% by the end of 2023. This transparent guidance is why long-term bond yields and residential mortgage rates have surged so far this year despite the actual policy rate having increased by only 0.75% since the Fed embarked on their rate hike cycle earlier this year.
Source: Bloomberg
Current market-based inflation expectations, which incorporate the Fed’s forward guidance, project inflation to return to below its long-term trend of 3% in just a few years. This suggests that the Fed will not have to “do more” than what they are currently forecasting with regards to raising interest rates and slowing the economy. The difference between their short-term policy rate and the 10-year Treasury yield also tends to compress as markets anticipate an end to the tightening cycle. This is what is called a flattening yield curve.
Bond performance has suffered this year, as the Federal Reserve raised interest rates and the purchasing power of the “fixed” income stream generated by this asset class is diminished by inflation. Markets have largely priced in the Fed’s suggested path for interest rates, consistent with other historic examples and periods. While it is folly to predict an absolute peak in any market, given the repricing that has already occurred for interest rates, we believe long-term yields are close to the upper end of their eventual range for this economic cycle.
Takeaways for the Week
The May employment report released this morning showed the labor market remains strong with 390,000 jobs added in the month, with particular strength in the leisure and hospitality sectors
This week, the Federal Reserve began allowing bonds held on its near $9 trillion balance sheet to mature without reinvestment as they pivot to “quantitative tightening” that will reverse the stimulus provided from their bond purchases earlier in the pandemic
*March 1980 through March 2020