All things considered bond investors should prepare for brighter days from both an income and capital appreciation perspective.
Recent data on inflation and labor markets and signals from the December Federal Open Market Committee (FOMC) meeting reinforce the assumption that the Fed is finished hiking rates this cycle. To be clear, economic activity indicate a decelerating economy, not an economy destined for a near-term recession, and while the Fed may not need to tighten further, it does suggest the central bank can keep rates higher for longer. Given the Fed is likely done tightening but will be in no rush to ease, investors are curious on how long-term rates may behave over the next year after spiking in the third quarter before settling down to ~3.9% at the time of writing.
While it’s not unreasonable to assume rates could move higher from here given quantitative tightening, softening demand for U.S. Treasury debt from foreigners and commercial banks, political uncertainty in Washington and increased Treasury supply due to higher deficit spending, history suggests (Exhibit 1A) that the timing of the last hike normally coincides with the peak in the U.S. 10-year Treasury yield. As highlighted, on average over the previous five tightening cycles, the U.S. 10-year has historically peaked 3 months prior to the last hike. Given the hawkish tilt in Fed commentary and firm economic data since its last hike in July, it’s not surprising yields may have peaked 3 months after in October this year.
Notably, not only do long rates tend to peak near the final rate increase, but long rates have also consistently declined following the end of a tightening cycle. On average, the U.S. 10-year has fallen by 107 basis points during the period between the last rate hike and the first rate cut (Exhibit 1B). Moreover, yields tend to fall further once the Fed begins cutting rates by an additional 46 basis points on average, six months after the first cut.
Since peaking at 5% in mid-October, the 10-year has already fallen by 1%, but we believe there is room for long-term rates to fall even further while Fed remains on hold, particularly if growth and inflation continue to trend lower. This suggests that investors should consider stepping out of cash and extending duration as falling yields could generate strong price appreciation in longer maturity bonds.
Lower rates, lower volatility
Over the past two years, aggressive tightening from the Federal Reserve, resilient data relative to expectations and technical factors have caused elevated interest rate volatility. Historically, as evidenced in Exhibit 2, interest rate volatility tends to be highest when the Fed first begins raising interest rates and when the Fed is cutting interest rates. This makes intuitive sense; when the Fed first begins hiking rates it is often unclear how high rates will go before economic activity begins to come under pressure, leading to uncertainty around the path forward for rates. Similarly, when the Fed is cutting interest rates, it is often in response to a recession leading to a quick shift in the outlook.
This cycle has experienced higher rate volatility than in any of the previous five rate-hiking cycles, and while volatility has come down slightly since July, it is still elevated relative to history. That said, we believe rate volatility should fall for two reasons. First, a decelerating economy should keep the Fed firmly on hold through the first half of 2024. Second, assuming the economy avoids a recession next year, we expect the Fed to reduce policy rates gradually and avoid a knee-jerk pivot to aggressive rate cuts.
Given this, rate volatility should continue to drift lower next year providing some much-desired stability in rates and helping support spread products. All things considered, bond investors should prepare for brighter days from both an income and capital appreciation perspective.