- Global Investment and Multi-Asset Strategist
Hong Kong (香港), Individual
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Cash with a roughly 5% yield is a beautiful thing. It’s been a boon to savers and acted as an offset to higher borrowing costs in mortgages, auto loans, and credit cards. It’s also cushioned consumption, which accounts for two-thirds of the US economy. According to the Commerce Department, US households are earning an additional US$121 billion increase in income on investments annually versus a year ago through June.
While it’s easy to get attached to high-yielding cash, especially when it yields more than some bonds, it’s also important to understand why it may be time to move into bonds. The bottom line is that holding cash while waiting until there’s more certainty in the economic outlook, the Federal Reserve’s (Fed) path, or the geopolitical environment could cost total return relative to bonds based on the past six interest-rate hiking cycles.
Our analysis looks at two timeframes. The first one starts at the last interest-rate hike in each Fed tightening cycle since 1983 (Figure 1). The second one starts at the first hike of each Fed-tightening cycle since 1983 (Figure 2).
Why has the experience in bonds been superior to cash? There are three key reasons:
- Whether or not the investment horizon begins with the first hike or the last hike of each Fed-tightening cycle, it incorporates the next Fed easing cycle when the yield curve steepens with short-term rates falling.
- The market anticipated rate cuts in each tightening cycle three to 13 months before the next rate cut, adding positive return in this period. Thus, an investor wanting to time the entry into bonds needs to be early. While bonds may not fare as well as cash if you’re early, we show that bond returns are comparable to cash in the short term, and the ensuing easing cycle more than compensates.
- Cash also tends to suffer during easing cycles as its yield drops along with Fed interest-rate cuts.
We analyzed the three-year total returns of cash, Treasuries, bonds (as represented by the Bloomberg Aggregate Bond Index), and corporate bonds (as represented by the Bloomberg US Corporate Bond Index) starting from the last hike of each of the past six full US Fed interest-rate tightening cycles since 1980. We also ran the same analysis giving cash an “advantage.” To do this, we began our total return analysis from the first hike instead of the last hike.
We did this because it’s less clear what a “pause” in this cycle means. It could mean a “skip” where the Fed skips a meeting before hiking again if inflation persists above target. Or it could be a longer period of policy inaction followed by the start of a new easing cycle. Thus, we wanted to see if bonds could outperform cash even after suffering drawdowns when the Fed was hiking interest rates. From the first hike, we can see that bonds may suffer relative to cash in the short term, but the ensuing easing cycle more than compensates for this and bond returns end up stronger on average during the six cycles we analyze.
Figure 1 illustrates that returns for all the bond strategies we observed were around double the returns of cash. Figure 2 shows that returns for the bond strategies were seven to 10 percentage points better than cash. In both analyses, corporate bonds outperformed Treasuries and the Bloomberg Aggregate Bond Index due to their higher yield and periods of spread compression, which added net positive return.
Figure 1
Figure 2
What are the risks? This cycle could be different. The Fed’s inflation fight today is tougher than it has been in past economic cycles, so the Fed may keep hiking rates or may need to stay on hold for longer at these higher rate levels. Recent concerns about federal debt could also weigh on US Treasuries and increase term premia in long bonds. Figure 2 is a conservative analysis that considers the first risk. Given the speed and magnitude of this hiking cycle, which began in March 2022, and the unprecedented -13% return for the Bloomberg Aggregate Bond Index in 2022, I have higher conviction that the Fed’s current hiking campaign is approaching the end. That being said, the potential distribution of returns in bonds is wider than cash.
Investment implications
Investors may want to consider moving out of cash into longer maturities sooner rather than later. Even though some bonds have lower yields than cash, they've benefited materially more than cash in the past six Fed rate-hiking cycles on average. Since the market anticipates the next easing cycle, much of the positive returns accrue around the time of the last hike.
Corporate bonds have a better average return profile than Treasuries and the bond index. Because corporate bonds have higher yield and spread-tightening potential, they've tended to outperform other fixed-income sectors.
An incremental step out of cash into bonds isn’t as big a risk as one might expect. Even if the Fed keeps hiking, our analysis indicates that bond returns would be comparable to cash in the short term, and bonds would outperform longer term based on past cycles.
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