Ever since the Federal Reserve started hinting it was planning to end its ultra-loose monetary policy, bond yields have been falling. That it happened in a booming economy with the highest inflation readings in nearly 40 years has taken a lot of investors and analysts by surprise. However, it’s a pattern that has occurred before, and may indicate that long-term bond yields already have peaked for this economic cycle.
In the past three rate-hike cycles (beginning in 1994, 1999 and 2015), 10-year Treasury yields posted interim highs six to 12 months prior to the initial rate hike by the Fed.
Ten-year yields have shown a pattern of declining well before the first Fed rate hike of a cycle
This market reaction reflects the power of the Fed’s signaling its policy intentions. The prospect of tighter monetary policy reduces expectations for growth and inflation down the road, which is supportive for long-term bonds. Consequently, Fed tightening cycles tend to be characterized by flattening yield curves—where short-term rates move up in tandem with Fed rate hikes while longer-term bond yields stabilize or fall. The Treasury yield curve has flattened sharply since the last Federal Open Market Committee (FOMC) meeting in September, when policymakers confirmed the Fed would begin tapering its bond purchases, a step toward reining in its loose policies.
Treasury yield curve, current vs the September FOMC meeting
Is it different this time?
Although we believe there is a good chance that bond yields have put in an interim high, it can be misleading to look at just one indicator from the past when forecasting the future. Every economic cycle has its own unique characteristics, and the current cycle is far different from most others, as it has largely been driven by the COVID-19 crisis. Moreover, compared to the past three Fed tightening cycles, inflation is starting at a much higher level, the economic expansion has been one of the strongest in modern history, and the Fed intentionally set its policy to lag inflation. As a result, real bond yields—adjusted for inflation expectations—are in steeply negative territory.
Real yields remain deeply in negative territory
As always, the major determining factor is going to be how the Fed reacts to the incoming economic data. In his recent congressional testimony, Fed Chair Jerome Powell confirmed that the Fed likely would speed up the tapering of its bond purchases and end them as early as March 2022. Once quantitative easing is over, the door would be open to rate hikes and a path to “normalization.”
At the upcoming December 14-15 meeting, we should get more clarity on how the Fed is approaching tightening. The Fed will release updated projections on economic growth and inflation as well as a new “dot plot,” which provides estimates from members of the monetary policy committee on the number and timing of rate hikes over the next few years. If the consensus estimates from the dot plot suggest a fast pace of rate hikes, such as three to four increases of 25 basis points each in the next year, then long-term bond yields likely will continue to fall and the yield curve flatten, as it would imply that the Fed was intent on slowing the economy’s growth rate quickly.
FOMC dot plot as of September
We expect the Fed to indicate a moderate pace for tightening policy. With the uncertainties around the emergence of the COVID-19 omicron variant, signs of economic slowing in China, and rising volatility in markets, the Fed will likely be hesitant to move policy too fast. It’s likely that inflation pressures will begin to ebb in 2022. Wholesale prices for many basic commodities are falling, inventories of consumer goods are recovering, and year-to-year comparisons of price increases could actually show some declines. Moreover, inflation expectations are still relatively low for the long term, despite the surge in current inflation. Looking at the inflation rates implied by the Treasury Inflation-Protected Securities (TIPS) market, it’s clear that expectations are high for the next few years, but low longer-term.
Market-based inflation expectations have come down from the November peak
The estimates for economic growth and inflation will need to be revised higher to reflect current trends, but the long-run projections will probably show a reversion to a slower trend. We would expect the Fed to signal one to two rate hikes in the second half of 2022.
What is “normal”?
From a longer-term perspective, the big question is what “normal” monetary policy looks like. After two decades punctuated by a financial crisis and a global pandemic that required extraordinary policy measures, determining the optimal interest rate is a significant challenge. Over the years, the Fed has steadily lowered its estimate of the terminal rate, from as high as 4.25% in 2012 to 2.5% in 2019 prior to the onset of the pandemic. However, the market is pricing in a terminal rate of only 1.75%, implying that economic conditions have changed enough that it will prevent policy from returning to pre-pandemic levels. The terminal rate estimate reflects the economy’s long-run potential growth rate, which has been trending lower for years largely due to demographic forces of aging populations globally.
The Fed’s view of the path of rate hikes versus the market’s view
As a result, it would not be surprising if the peak in 10-year yields reached earlier in 2021, in the 1.75% region, represented a peak for the next year. However, we continue to believe investors should be cautious about adding too much duration to their portfolios at current yields. We are optimistic about economic growth in 2022 and see the potential for yields to bounce higher from current levels. Forecasting the path of interest rates in this cycle is likely to be more challenging than usual—for both the central bank and investors. We favor keeping average portfolio duration low, but averaging into higher yields using bond ladders or a barbell over time.
Important disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
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Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. As compared to other fixed income products and strategies, engaging in a bond ladder strategy may potentially result in future reinvestment at lower interest rates and may necessitate higher minimum investments to maintain cost-effectiveness.
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