With the Fed poised to further raise rates this year as well as next, it is insightful to investigate how a bond’s duration can impact its return in a rising interest rate environment. Typically, a bond’s duration is used to gauge its price sensitivity to changes in interest rates. As most investors know, bond prices are inversely related to interest rates; the longer the duration, the greater the sensitivity to interest rate movements. In the event of rising rates, all else equal, a bond with a higher duration will decline more in price.

As a simple illustration of how duration can affect bond prices in times of rising interest rates, we compare the performance of short bonds — measured by the Barclays 1–3 Year Govt/Credit Index — and long bonds — measured by the Barclays Long Govt/Credit Index. At this point, the Federal Reserve is likely to announce two more interest rate hikes in 2018, with each hike expected to be 25 basis points. The respective durations for the two indices used in the analysis are approximately 1.9 and 14.9, respectively. Assuming a parallel shift in the yield curve and keeping other economic variables constant, the index values will decrease by 0.95% (short bonds) and 7.45% (long bonds), given the 0.5% increase in interest rates by the end of 2018. If this is true, does this mean that short duration bonds always outperform long duration bonds when interest rates goes up?

On average, the annualized cumulative return over seven interest rate rising periods since 1976 on the Barclays 1–3 Year Govt/Credit Index is 4.69% and 3.4% for the Barclays Long Govt/Credit Index. The correlation with interest rates is also consistently high for short duration bonds at 87% as opposed to 24% for long duration bonds.

At this point, the numbers suggest that short duration bonds tend to outperform when interest rates rise. However, the last two periods in the chart show the opposite trend — long bonds have actually outperformed their shorter duration counterparts. How so? A primary reason is how the shape of the yield curve changed during the last two interest rate increases, as not all rate increases are parallel shifts of the entire curve. The shifts in the yield curve for the periods 1994–1995 and 1999–2000 were indeed parallel whereas the last two periods featured rises on almost exclusively the short end of the yield curve. Rates were anchored on the long end during these periods due to demand from foreign investors looking for greater yield than offered by their home countries, particularly in Europe and Asia.

Overall, the chart shows that short duration bonds provide a more predictable return when rates rise, however a non-parallel shift in the yield curve can influence their relative performance vs. longer duration bonds. For institutional investors, if nothing else this serves as a reminder that trying to time interest rates and changes to the shape of the yield curve is an utterly difficult task to consistently get right, so investors are best served maintaining and re-balancing their bond allocations as dictated by their investment policy statements.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Our chart for this week examines the shape of the U.S. Treasury yield curve. With the 10-year Treasury yield recently rising above 3%, the yield curve is now as flat as it was in 2007, just before it inverted as a precursor to the 2008 financial crisis. An inverted yield curve shows that the market does not expect future interest rates to be as high as today’s interest rates, and may signify an economic downturn — going hand-in-hand with an equity and credit correction — to come.

The horizontal axis shows the maturities of U.S. Treasury bonds while the vertical axis shows their yields. Each line is a cross-sectional snapshot — rather than a time-series — of the U.S. Treasury yield curve. The bottom-most line is the spot curve, which shows the current¹ U.S. Treasury yield curve. The next line up is a Treasury forward curve that shows where the market expects the yield curve to be at the end of 2018. The next line up after that shows the forward curve for one year later, at the end of 2019; and the highest line shows the forward curve for the end of 2020.

As we can see, the market expects the curve to pivot at the long end, and rise at the short end, suggesting further flattening.

While it is comforting to know that the Federal Reserve now has in its toolbox the ability to cut rates to support the economy, it is a concern how easily the curve could invert, say, if the Fed hikes only a few more times coupled with a drop in the long end of the curve. This drop could be due to a resurgence of geopolitical tensions or slower growth expectations.

The Fed continues to have the dual mandate of minimizing unemployment while containing inflation. As inflation and inflation expectations continue to rise, we may see the Fed continue its rate hikes in order to rein in the economy, making inversion that much more likely. Because of this, we encourage investors to be on guard for curve inversion, which means taking moderate risk in portfolios, remaining diversified and maintaining a suitable amount of duration. We will continue to monitor the likelihood of curve inversion in the quarters to come — in the context of key metrics such as valuations, fundamentals and technicals — to help ensure that our clients’ portfolios are well-positioned.

¹ Data as of May 18, 2018

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The U.S. Treasury yield curve is flatter today than it was at the end of the Great Recession in 2009.  This week’s chart examines how flat the curve is now, and the potential for further flattening, possible inversion, or potential steepening. The 10s minus 2s steepness shown in the chart is the 2-year Treasury yield subtracted from the 10-year Treasury yield.

In general, a steep yield curve signifies a growing economy and a bullish market, as long-term bonds must provide greater yields to keep up with future growth. On the other hand, an inverted yield curve signifies a shrinking economy and a bearish market, as investors buy long-term bonds as safe havens, thereby driving their prices up and lowering their yields. As we can see from the chart, the yield curve inverted prior to the 2000 tech bubble burst and prior to the 2008 Great Recession.

With the Tax Cut now signed and underway, we would theoretically expect the yield curve to steepen as the market expects stronger economic growth. However, in the fourth quarter of 2017 — as the legislation gained momentum through Congress and was ultimately signed into law by Trump — the yield curve flattened instead. This is a possible sign that much of the tax stimulus may have already been priced into assets.

Previous Fed Chairs Greenspan and Bernanke both said the economy would be fine after the yield curve inverted in 2000 and 2008, respectively. Going forward, we may expect that the new Fed Chair Jerome Powell will be more cautious in preventing inversion.

Prospects for curve steepening still exist, as inflation — which rose recently — may continue to rise as the economy benefits from the Tax Cut. Rising inflation would then be expected to raise the long end of the yield curve. However, we continue to see the mitigating effect of overseas reach for yield, as U.S. rates across the curve still outyield rates from the rest of the developed markets. Non-U.S. pensions, insurers, and banks continuing to buy long U.S. bonds may drive up prices and keep yields low on that segment of the curve.

Given the flat yield curve, we recommend maintaining an allocation to core bonds for yield, diversification, and principal protection, as well as the inherent moderate duration position.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

 

As America’s central bank, the Federal Reserve is tasked with the important power of keeping our nation’s employment and inflation within a range that is conducive to prosperity. The Fed does this by controlling interest rates. By keeping interest rates low, the Fed enables businesses to borrow more easily, thereby increasing employment, but at the risk of raising inflation to levels that could be too high. In Fed-speak, the Fed is being dovish when it keeps rates low to stimulate the economy — stepping on the gas versus pumping the brakes. On the other hand, if the Fed raises interest rates, it is harder for businesses to borrow, thereby containing inflation, but at the risk of raising unemployment. In this case, the Fed is hawkish when it raises rates to rein in the economy — pumping the brakes.

This week’s chart looks at the dovishness or hawkishness of the Federal Open Market Committee, the committee within the Federal Reserve that sets interest rates. The committee is going through much change: Jerome Powell — a dove — was recently nominated by Trump to Fed Chair starting in 2018 and was affirmed by the Senate. Janet Yellen — a dove — will be stepping down as Fed Chair at the end of this year. Randal Quarles — a centrist — recently joined the committee.

The Fed publishes the committee’s membership for each of the next three years. By assessing the recent speeches and papers from each member, we constructed a Dove-O-Meter to show how dovish or hawkish the group is expected to be. It is important to note that the Fed board of governors, which comprises a large portion of the Federal Open Market Committee, will have four empty seats out of seven total once Yellen steps down, so there may be some change to the dovishness or hawkishness of the group as Trump continues to nominate more people. However, with the members that we know will be on the committee, we can expect a relatively centrist Fed in 2018 and a relatively dovish Fed in 2019 and 2020, as shown in the chart. A centrist Fed in 2018 may be more balanced in normalizing rates and its balance sheet, while a dovish Fed in 2019 and 2020 may lean towards hiking rates less and trimming its balance sheet less to continue to be more stimulative.

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