The 4 Stages of a Rate Cycle
We more than doubled our portfolios’ duration in a single day this summer. Since then, many have asked: If RBA thinks inflation can be persistent and on a secular basis continue to surprise to the upside, why would we overweight long-term Treasuries? The answer lies in the nuances of how interest rates have historically behaved during different economic, profit, and tightening cycles. We believe sentiment has exited Stage 2 and is now in the early part of Stage 3: a period when the market begins to price in lower long-term growth as a profit recession looms.
Stage 1 and 2: Underweight Duration
Stage 1: Ready, set, rise
The first stage of a rate cycle presents itself when Treasury yields are at rock bottom, the Federal Reserve’s policy stance is maximum dovishness and profit and economic growth is at or near a trough. In this current cycle, August 4th, 2020 marked the start of Stage 1. With financial conditions supportive of higher inflation and economic and profit recovery, rates across the curve always increase during Stage 1. As RBA was throughout 2021, this is the time for maximum underweight of duration.
Stage 2: Blow off the top
The second stage of a rate cycle is marked by strong growth and inflation and a Fed that goes from easy (QE, low Fed Funds) to less easy (tapering asset purchases) to modestly tightening (first rate hike). Like Stage 1, this environment is a recipe for higher rates and is generally characterized by a steeper, but overall higher yield curve. During Stage 2, the market begins to lose confidence in the Fed’s ability to slow growth and inflation, often leading to a “blow off the top” in Treasury yields that sends the near-term forward spread (the difference between the current 3-month T-bill and its expected rate 6 quarters in the future) to extremes. During this phase, the Fed isn't doing enough to slow nominal growth, so long-end yields go up by more than short-end yields, a phenomenon known as “bear steepening.”
Stage 3 and 4: Overweight Duration