- Global Investment and Multi-Asset Strategist
Iceland, Institutional
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With US 10-year yields close to 5% and the end of the year approaching, it may be time to consider whether to move from cash to bonds. In August, I showed the potential benefit of bond investments even when it’s uncertain how long the Federal Reserve (Fed) will remain in interest-rate-hiking mode. Today, there’s a bit more clarity on the Fed, with markets expecting the central bank to remain on hold and begin cutting rates by mid-2024 as of this writing. Still, we don’t know for sure that the Fed is done. So I’ve taken a fresh look at why it may be better to be early than late to bond investments around the time of the last hike.
What we can learn from past rate-hiking cycles
Using data from the past six Fed rate-hiking cycles, Figure 1 shows the average three-year total return advantage of being in the US aggregate bond index if an investor was three, six, or 12 months early relative to the last hike (left side of the chart) and three, six, or 12 months late relative to the last hike (right side of the chart). The light-blue shaded areas represent the lost total return compared to timing the last hike perfectly, shown in the middle bar, or the “cost of mistiming” the last hike. The orange shaded area is the additional total return earned compared to timing the last hike perfectly.
The key takeaway from the chart is that it was better to be early than late. The reason is that investors don’t have perfect foresight and thus tend to price in expectations ahead of the actual event. Being three months early achieved the maximum return and being six months early was not far off and was very close to being “on time.” Finally, it was costly being late. The opportunity cost of being just three months late was an average of six percentage points and the cost rose if one was even later.
Figure 1
Why the Fed may give hiking a rest
Rising bond yields have repeatedly surprised markets over the past year, so what gives me more confidence that we’re nearing the end and moving into bonds may be a prudent strategy now? Inflation is declining. Core consumer price inflation has moved steadily down from 6.6% to 4.4% over the past 12 months. The spike in bond yields is tightening financial conditions by making it more costly to borrow. As the Fed’s recent statement alluded to, higher bond yields are doing some of the tightening work for them — a view that will likely factor into the Fed’s rate decisions over the coming months. Finally, I see evidence the Fed’s cumulative 550 basis points of rate hikes are feeding into the real economy but with a longer lag than usual. Banks’ lending conditions are tightening, US equity markets are less buoyant, and wages are coming off the boil.
How could I be wrong? Labor markets are still very tight and while wages have come down, they are still inconsistent with 2% inflation. Unemployment may need to be meaningfully higher than the Fed’s forecast of 4% to bring wages and inflation down sustainably enough to achieve their target and that would mean more tightening is necessary. Even if that is the case, however, having a three-year investment horizon could still bring a total return advantage to bonds relative to cash, as more tightening would also revive fears of recession, a good thing for bonds as it would turn the Fed’s focus to rate cuts. Finally, a longer-term concern is the term premium (the additional yield investors require as compensation for holding longer-term bonds), which has risen recently in response to a myriad of factors. Should the term premium on US Treasury bonds rise further due to increasing US government deficits and bond supply, that could inhibit any meaningful bond rally.
Investment implications
- Investors may want to consider moving out of cash and into longer maturities sooner rather than later (assuming they are comfortable with the higher risk inherent in bonds versus cash). Bonds now have comparable yields to cash and, while past results are no guarantee of future performance, they have benefited materially more than cash in the past six Fed interest-rate-hiking cycles on average over a three-year horizon. Since the market tends to anticipate the last hike, much of the positive return has accrued before that.
- An incremental step out of cash into bonds may not be as big a risk as some expect. Even if the Fed keeps hiking, the market can’t have perfect foresight about the timing of the last hike. The key is that the tightening cycle is likely either over or close to the end, in which case yields will likely stabilize or rally.
- Investors can make this move incrementally by moving into the intermediate part of the yield curve. As markets anticipate the end of the Fed’s tightening cycle, the yield curve steepens, which benefits the intermediate part of the curve as much or more than the long end.
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