Has the Worst Passed for Fixed Income Markets...Or Is It Yet to Come?
While working through any kind of volatility or uncertainty in the markets — whether it’s the global financial crisis (GFC), COVID or the tech bubble — the old phrase, “This time it’s different,” usually pops up around the water cooler and throughout media. We are in the early stages of the first and possibly most significant tightening cycle in our history as the Federal Reserve attempts to temper red-hot inflation, maintain a strong labor market and reduce its nearly $9 trillion balance sheet.
What better way to try to understand the present and potential future than by looking back at the past? Specifically, examining previous rate hikes and trends in the market to see why this time, it truly is different. When looking back at different environments, one must consider variables impacting the markets at that specific time, whether it be a pre-emptive move by the Fed to slow a red-hot economy and crush inflationary pressures with the first interest rate hike in five years (1994), the lead up to the GFC (2004) or the first move off a zero-bound range in seven years (2015).
For this analysis, we looked at the three most recent rate hiking cycles (1994-1995, 2004-2006 and 2015-2018) and compared the lead-up to those cycles to the current environment. (The rate cycle of 1999-2000 was excluded from the analysis as that cycle started shortly (just seven months) after the previous easing cycle ended). Our analysis examines the 250 business days leading up to the initial rate hikes of each cycle to gauge market expectations for the 2-year Treasury as well as the length of time the 2-year Treasury took to reach each cycle’s terminal rate. Based on our analysis, it looks like this time really could be different.
Exhibit 1 examines the starting yield for the 2-year Treasury and its level on the day before the first interest rate hike from the Fed. This most recent cycle has witnessed the largest impact on the 2-year Treasury, both on an absolute yield and percentage basis, up 169 basis points (bps) or 1,056%. This is more clearly illustrated in the subsequent exhibits, which cover the 250 days prior to the initial rate hike through the end of the rate hike cycle. Exhibit 1 also includes the performance of the Bloomberg 1-3 Government/Credit Index over the same time periods, followed by a recap of the previous tightening cycles.
Exhibit 1 — 250 Days Preceding Initial Rate Hike
||2-Year Treasury Yield (%)
||1-3 Year Gov/Credit Total Return
|16 Feb 1993 to 3 Feb 1994
|16 Jul 2003 to 29 Jun 2004
|31 Dec 2014 to 15 Dec 2015
|31 Mar 2021 to 15 Mar 2022
1994 — 1995
Expectations leading into the Fed tightening cycle were for the Fed to raise rates by roughly 125 bps to a terminal level of 4.25%. Instead, the Fed was much more aggressive than expected and increased the fed funds rate to 6.00% by the end of the tightening cycle, doubling from the starting point of 3.00%. As illustrated in Exhibit 2, the 2-year Treasury yield held steady leading up to first rate hike and then moved closely in-line with subsequent rate hikes before rapidly accelerating near the end of the cycle once it became clear the Fed would continue raising the short end of the curve, overshooting a bit before settling near 6.75% in early 1995. Part of the more aggressive acceleration was tied to the Fed’s aggressive approach with rate hikes — after starting out with three 25 bps rate hikes, the Fed followed up with two 50 bps hikes and a 75 bps hike before finishing the cycle with a 50 bps increase. Once the Fed began the process of hiking interest rates on 4 February 1994, it took 65 days for the 2-year Treasury to reach the terminal yield targeted by the Fed (6.00%), reflecting the market’s uncertainty with how aggressive the Fed would move.
Exhibit 2 — Fed Tightening Cycle 1994 – 1995
2004 — 2006
Once more, the Fed exceeded expectations, with investors looking for an increase in the fed funds rate from 1% to a terminal rate of 4% but the Fed pushed further, hiking rates to the final level of 5.25% by the end of June 2006 for that cycle. That’s 17 rate hikes (each 25 bps) from the start of the cycle in 2004 to the end of the cycle in 2006 (Exhibit 3). We saw a similar pattern to what we saw during the 1994 cycle, though with a more aggressive shift higher leading up to the initial rate hike. But once the tightening cycle commenced, it was a steady climb higher with the 2-year and the fed funds rate nearly in lockstep before settling near the terminal rate in mid-2006. Unlike the rapid move higher during the 1994 cycle, where the terminal rate was reached in 65 days, it took the 2-year Treasury 517 of the 549-day cycle to reach the terminal rate (5.25%).
Exhibit 3 — Fed Tightening Cycle 2004 – 2006
2015 — 2018
The most recent tightening cycle should still be fresh in everyone’s minds as it started roughly seven years ago and wrapped up by the end of 2018. The Fed was deliberate with its plans for the tightening cycle, with one 25 bps increase in both 2015 and 2016, followed by three increases in 2017 and four increases in 2018, finishing with a terminal range of 2.25% to 2.50%, using the range methodology established following the GFC. The 2-year Treasury yield was fairly stable heading into the tightening cycle and moved directionally with the fed funds rate until a bit of an acceleration to match the Fed’s moves in 2018 before finishing closely in-line with the terminal rate.
The dip at the end of the chart represents the expectation for a pause and then a rate cut as trade war rhetoric and economic slowdowns became a bigger concern. The cycle from start to finish encompassed 816 business days and the 2-year Treasury reached the high end of the Fed’s range within 571 business days. The tightening cycle ended on 19 December 2018, but easing was right around the corner as the Fed would lower rates from the terminal range of 2.25% – 2.50% to 1.50% – 1.75% by the end of 2019.
*Prior to pushing rates to near zero (0.00% 0.25%) during the GFC, the fed funds rate was a number, not a range. Ever since the GFC, the Fed has communicated the fed funds rate within a 25 bps range, so for charts post-2008, we’ve utilized the lower bound of the communicated range.
Exhibit 4 — Fed Tightening Cycle 2015 – 2018
2022 — ?
Unlike other pre-tightening cycles, the markets pushed the 2-year Treasury yield higher to adjust for the upcoming rate hiking cycle well before it even began. In the 250 days leading up to the initial rate hike on March 16, the 2-year Treasury yield climbed 169 bps or 1,056% from its starting level (Exhibit 5). As we move further from the initial rate hike, the Fed has been preparing the markets for an even more aggressive approach. At the end of April, the market interpretation of recent comments from Powell and other members of the Federal Open Market Committee (FOMC) pushed the terminal rate from 2.75% to 3.00% by February 2023 while the 2-year Treasury adjusted as well.
Once the markets moved past the initial rate hike, the 2-year Treasury yield continued its climb higher, increasing by 78 bps from 1.94% post-FOMC meeting to 2.72% by the end of April. By ending the month of April at that level, the 2-year Treasury yield is just 28 basis points below the expected terminal rate of 3.00% for this cycle, as dictated by the federal funds futures market pricing for February 2023.
Exhibit 5 — Fed Tightening Cycle 2022 and Beyond
What accounts for the variance between the current level on the 2-year Treasury and the terminal rate? There are a couple of theories. First, higher than expected inflation as well as the first negative gross domestic product (GDP) print since the COVID pandemic-fueled drop in Q2 2020 combined to generate more uncertainty for the future path of interest rates. Second, it could be the perceived impact of the Fed’s potential decision to actively sell securities from its balance sheet; Jerome Powell was quoted in March as saying that the effect of shrinking the balance sheet this year is equal to an additional quarter-percentage-point increase in the fed funds rate. So, futures are pricing in the potential move to actively sell securities by the Fed but not yet priced into the 2-year Treasury?
On the heels of the worst start for the fixed income market in our lifetimes, what are the prospects going forward? We are not in the business of predicting the future and would not put clients’ money at risk based on our prognostication of the future path of interest rates. But based on what we’ve learned from examining the past, we could theorize that the shorter end of the Treasury curve doesn’t have much further to climb and could be within a tighter trading range for the foreseeable future, as it remains within striking distance of the expected terminal rate.
With the 2-year Treasury yield only 28 bps below the terminal fed funds rate for this hiking cycle, the main concern for the short end of the Treasury market would be day-to-day volatility brought about by headlines and geopolitical risks, continued spread widening and the future path of inflation. For the longer end, concerns around the economy as well as the Fed’s plans for its balance sheet dominate expectations. One need look no further than early April, when Lael Brainard referred to the task of reducing inflation as “paramount” and said the central bank will raise rates steadily while starting balance sheet reduction as soon as May. The reaction from the markets? On that day (April 5), the 10-year Treasury yield jumped 15.2 bps and it has risen nearly 60 bps since the start of April, finishing the month at its highest level since 8 November 2018 (3.24%). So, for the shorter end, carry and additional yield while managing credit risk will be key from now until the end of the year; while for the longer end, mitigating interest rate risk and duration extension risk will dominate, as will the management of spread sectors such as investment grade corporate debt.
Bloomberg US 1-3 Year Government/Credit Index measures the performance of investment grade government and corporate bonds with maturities of one to three years. The index is unmanaged, includes net reinvested dividends, does not reflect fees or expenses (which would lower the return) and is not available for direct investment. Index data source: Bloomberg Index Services Limited. See diamond-hill.com/disclosures for a full copy of the disclaimer.
The views expressed are those of Diamond Hill as of May 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.