Bond Surprises
It’s not what you don’t know that kills you, it’s what you know for sure that ain’t true.
— Mark Twain
At the start of 2024, markets were pricing in seven Fed rate cuts, today it stands at two.
The base investment case that many banks and investment strategists make is that inflation will be coming down this year.
A popular trade to take advantage of this "obvious information” is to buy long dated bonds and wait patiently for the '“inevitable” cut in interest rates which will then boost prices of the bonds you are holding.
Let’s investigate if this is true.
Spread between Federal Funds Rate and U.S. 10-Year Treasury Yields
The graph above plots the difference (the spread) between the yields of the Federal Funds Rate (FFR — also loosely known as interest rates in the U.S.) and the yields of the U.S. 10-Year Treasury bonds (10Y UST).
Over the past three decades, the Federal Reserve has cut rates three times — the years 2000, 2007, and 2019. All three historical rate cuts came after a period of yield curve inversion (i.e. when short duration bonds yield more than longer duration bonds) highlighted in red in the chart above.
The bottom half of the chart highlights the spread in yellow between the FFR and 10Y UST yields.
If the thesis is that cuts in the FFR will lead to bonds rallying across the board, you would not expect to see large spreads when rate cuts occur; instead, you would expect spreads to compress, with both yields of the FFR and 10Y UST moving lower.
In reality, sometimes the opposite happens. Spreads widen even further, leading to more losses for holders of longer duration bonds. For example, although the two rates tend to move in a similar way, the correlation in yields is noticeably lower when compared to maturities that are closer to the Fed Funds.
Whilst the Fed does control interest rates on the short end, markets are more free to set interest rates further out the yield curve — reflecting investors opinions about the future. Factors such as demand for term premium and inflation expectations can also affect yields further out the maturity scale.
Invest, don’t speculate
The next time someone says that they expect rates to come down, it is important to be clear on which rates they are referring to. Keep this in mind if you are positioning your portfolio for potential Fed rate cuts. History is pretty clear that even if the Fed does cut rates this year, it does not mean that the UST 10-Year yield will move in tandem.
There is nothing certain in the world of investing. Inflation and FFR forecasters have had to reverse their positions dramatically this year. Rather than rely on forecasts which has proven to be ineffective, trust market prices and rely on the evidence to make your investment decisions. Click here to find out more.
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