Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
I was asked a pretty good question following an internal meeting late last week. The question started out by noting that we have been promoting going longer on the curve for a while now and then asking why we think longer-term rates will come down. Is it possible for shorter-term rates to decline while the 10-year-plus levels stay higher as the economy improves?
First, all things are possible. We find ourselves in very tentative times with volatility and a whole lot of investor uncertainty. When you look at previous Federal Reserve interest-rate-hike cycles, it is common to see short-term rates more sensitive to Fed interest rate hikes versus the longer end of the curve. The gold line in the graph represents the 1-year Treasury and the green line the 10-year Treasury. The white line or shaded blue area represents the 525 basis points in Fed Funds hikes initiated by the Federal Open Market Committee. When the green and gold line (1yr and 10yr Treasury) cross over, that is when the Treasury curve inverts (short rates move higher than long rates). The one-year Treasury rate follows the Fed interest rate hikes more closely than the 10-year Treasury does. Historically, when the Fed appears to have completed hiking the Fed Funds rate, short-term interest rates begin to fall faster versus the 10-year rates and the curve begins to “normalize” (long-term rates are higher than short-term rates).
One day the market reacts to the idea that interest rates will remain higher for longer. The next day, there is a flight to quality triggered by the Israeli/Hamas conflict which brings rates down. The next day employment figures are healthy but inflation ticks back up suggesting the Fed may have good reason to hike rates one more time. This day-to-day tug-of-war with the market delivers uncertainty which has led to much market volatility.
Since June, long-term rates have elevated faster than short-term rates which is an occurrence known as a bear steepening curve. This is occurring while the Treasury curve is still inverted and rates remain very attractive across the curve. Despite the uncertainty and volatility, what we do know is that interest rates are elevated to levels not seen in 16+ years. Whether short-term rates fall or long-term rates remain higher for longer, at the end of the day, investors’ yield opportunities remain above ordinary. Investors can lock into growth-like returns with individual bonds providing stable cash flows and income streams. Locking in for longer alleviates reinvestment risks associated with buying on the short end. Although the yield curve shape may morph in a couple of different ways, focus on the yield opportunities it is providing investors right now.
