by Kathy Jones, Head of Fixed Income, Charles Schwab & Company
Ever since the Federal Reserve started hinting it was planning to end its ultra-loose monetary policy, bond yields have been falling. That it happened in a booming economy with the highest inflation readings in nearly 40 years has taken a lot of investors and analysts by surprise. However, it’s a pattern that has occurred before, and may indicate that long-term bond yields already have peaked for this economic cycle.
In the past three rate-hike cycles (beginning in 1994, 1999 and 2015), 10-year Treasury yields posted interim highs six to 12 months prior to the initial rate hike by the Fed.
Ten-year yields have shown a pattern of declining well before the first Fed rate hike of a cycle
Source: Bloomberg. U.S. Generic 10-year Treasury Yield (USGG10YR INDEX), using weekly data. Past performance is no guarantee of future results.
This market reaction reflects the power of the Fed’s signaling its policy intentions. The prospect of tighter monetary policy reduces expectations for growth and inflation down the road, which is supportive for long-term bonds. Consequently, Fed tightening cycles tend to be characterized by flattening yield curves—where short-term rates move up in tandem with Fed rate hikes while longer-term bond yields stabilize or fall. The Treasury yield curve has flattened sharply since the last Federal Open Market Committee (FOMC) meeting in September, when policymakers confirmed the Fed would begin tapering its bond purchases, a step toward reining in its loose policies.
Treasury yield curve, current vs the September FOMC meeting
Source: Bloomberg, data as of 12/7/2021 and 9/22/2021. Past performance is no guarantee of future results.
Is it different this time?
Although we believe there is a good chance that bond yields have put in an interim high, it can be misleading to look at just one indicator from the past when forecasting the future. Every economic cycle has its own unique characteristics, and the current cycle is far different from most others, as it has largely been driven by the COVID-19 crisis. Moreover, compared to the past three Fed tightening cycles, inflation is starting at a much higher level, the economic expansion has been one of the strongest in modern history, and the Fed intentionally set its policy to lag inflation. As a result, real bond yields—adjusted for inflation expectations—are in steeply negative territory.
Real yields remain deeply in negative territory
Source: Bloomberg. US Generic Govt TII 10 Yr (USGGT10Y INDEX) and US Generic Govt TII 5 Yr (USGGT05Y INDEX). Daily data as of 12/7/2021. Basis points (bps) are a unit of measure of rate changes; one basis point equals 0.01%, or 0.0001. Past performance is no guarantee of future results.
As always, the major determining factor is going to be how the Fed reacts to the incoming economic data. In his recent congressional testimony, Fed Chair Jerome Powell confirmed that the Fed likely would speed up the tapering of its bond purchases and end them as early as March 2022. Once quantitative easing is over, the door would be open to rate hikes and a path to “normalization.”
At the upcoming December 14-15 meeting, we should get more clarity on how the Fed is approaching tightening. The Fed will release updated projections on economic growth and inflation as well as a new “dot plot,” which provides estimates from members of the monetary policy committee on the number and timing of rate hikes over the next few years. If the consensus estimates from the dot plot suggest a fast pace of rate hikes, such as three to four increases of 25 basis points each in the next year, then long-term bond yields likely will continue to fall and the yield curve flatten, as it would imply that the Fed was intent on slowing the economy’s growth rate quickly.
FOMC dot plot as of September
Source: Bloomberg. FOMC dot plot as of 9/22/2021.
We expect the Fed to indicate a moderate pace for tightening policy. With the uncertainties around the emergence of the COVID-19 omicron variant, signs of economic slowing in China, and rising volatility in markets, the Fed will likely be hesitant to move policy too fast. It’s likely that inflation pressures will begin to ebb in 2022. Wholesale prices for many basic commodities are falling, inventories of consumer goods are recovering, and year-to-year comparisons of price increases could actually show some declines. Moreover, inflation expectations are still relatively low for the long term, despite the surge in current inflation. Looking at the inflation rates implied by the Treasury Inflation-Protected Securities (TIPS) market, it’s clear that expectations are high for the next few years, but low longer-term.
Market-based inflation expectations have come down from the November peak
Source: Bloomberg. U.S. Breakeven 10 Year (USGGBE10 Index). Daily data as of 12/7/2021.
The estimates for economic growth and inflation will need to be revised higher to reflect current trends, but the long-run projections will probably show a reversion to a slower trend. We would expect the Fed to signal one to two rate hikes in the second half of 2022.
What is “normal”?
From a longer-term perspective, the big question is what “normal” monetary policy looks like. After two decades punctuated by a financial crisis and a global pandemic that required extraordinary policy measures, determining the optimal interest rate is a significant challenge. Over the years, the Fed has steadily lowered its estimate of the terminal rate, from as high as 4.25% in 2012 to 2.5% in 2019 prior to the onset of the pandemic. However, the market is pricing in a terminal rate of only 1.75%, implying that economic conditions have changed enough that it will prevent policy from returning to pre-pandemic levels. The terminal rate estimate reflects the economy’s long-run potential growth rate, which has been trending lower for years largely due to demographic forces of aging populations globally.
The Fed’s view of the path of rate hikes versus the market’s view
Note: The 12/15/2027 Eurodollar futures rate was used for the Longer-Run market rate.
Source: Bloomberg. Fed estimate as of 9/22/2021. The market estimate of the federal funds rate using Eurodollar futures (EDSF). As of 12/7/2021.
As a result, it would not be surprising if the peak in 10-year yields reached earlier in 2021, in the 1.75% region, represented a peak for the next year. However, we continue to believe investors should be cautious about adding too much duration to their portfolios at current yields. We are optimistic about economic growth in 2022 and see the potential for yields to bounce higher from current levels. Forecasting the path of interest rates in this cycle is likely to be more challenging than usual—for both the central bank and investors. We favor keeping average portfolio duration low, but averaging into higher yields using bond ladders or a barbell over time.
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