- Rate increases since 1979 show long-term U.S. debt outperforms
- ‘Not the start of a bear market,’ according to JPMorgan's Tan
There’s been plenty of prognosticating about what will happen to the bond market’s unprecedented bull run once U.S. interest rates start rising from rock-bottom levels.
A quick scan of history provides plenty of support for the optimists.
Every time the Federal Reserve has raised rates over the past four decades, betting that longer-term Treasuries would outperform short-term debt has proved to be a big winner as higher rates stemmed inflation and kept economic growth from overheating, according to data compiled by Bloomberg. What’s more, returns consistently exceeded corporate bonds in the first year of tightening, with Treasuries underperforming just once.
And it’s not just past performance that suggests Treasuries will remain in demand. With little inflation in sight, a cloudy global outlook and the weakest U.S. expansion in decades, there aren’t many reasons to compel the Fed to move quickly or aggressively. That backs up the view of a client survey by JPMorgan Chase & Co., which showed investors were more bullish on Treasuries than at any time since 2013.
“This is not the start of a bear market in Treasuries,” said David Tan, the London-based head of rates at JPMorgan Asset Management, which oversees $1.7 trillion. He’s “overweight” 30-year U.S. bonds and “underweight” five-year notes.
While debt investors have consistently been right in dismissing naysayers calling for the end to the three-decade bull market in bonds, the stakes are rising with the Fed all but certain to end its seven-year policy of holding rates at virtually zero on Wednesday.
Any missteps during what may be a years-long process of tightening have the potential to extend well beyond the bond market and spill into the broader economy. That’s because Treasuries serve as the borrowing benchmark for governments, businesses and consumers around the world.
Yields on 10-year notes, which guide interest rates on trillions of dollars of debt, are about 2.19 percent, close to where they were a year ago. In 2010, yields were as high as 4.01 percent.
The Fed is now about to embark on its sixth tightening cycle since 1979. Traders are pricing in a 76 percent chance policy makers will raise the target rate by 0.25 percentage point on Dec. 16, data compiled by Bloomberg show.
In the five previous periods, bond traders have consistently favored long-term Treasuries as the so-called yield curve flattened each time.
The metric, which measures the extra compensation investors demand to take on the added risk of holding securities that take longer to pay back, showed the gap between two- and 10-year Treasuries narrowed an average 0.56 percentage point in the year following the Fed’s first increase, data compiled by Bloomberg show.
A big part of the reason longer-term debt has done better is that higher borrowing costs tend to slow spending and growth. It also shows investors have confidence in the Fed’s ability to contain inflation, which is a big risk for anyone holding fixed-rate bonds, especially when the interest is paid out over an extended period of time.
Since the late 1970s, “the Fed has gained a lot of credibility in getting inflation under control and the long end has responded very predictably,” said Brandon Swensen, the co-head of U.S. fixed-income at RBC Global Asset Management, which oversees $35 billion.
Treasuries have also been a better bet for bond investors than corporate debt at the start of tightening cycles. On average, government securities have outperformed by 2.56 percentage points, with Treasuries falling behind only during the first year after the Fed started to raise rates in 2004.
In 1994, when then-Fed Chairman Alan Greenspan shocked the markets by ratcheting up rates 3 percentage points in a year, Treasuries held up better than company bonds.
This time, Fed Chair Janet Yellen, who has repeatedly signaled that rate increases will be “gradual,” has little incentive to go off script.
Anything more hawkish may snuff out what little inflation the economy is generating, particularly as the slump in oil deepens. Consumer prices haven’t increased more than 0.2 percent in any month this year, and have stagnated or fallen in six of the past 10 months. The Fed’s own goal is 2 percent.
Even as the jobless rate plummets, a lack of consistent wage growth is holding back growth. The economy expanded at an annual pace of 2.1 percent in the third quarter, less than at the start of any other tightening cycle, when growth averaged more than 3 percent.
In Congressional testimony on Dec. 3, Yellen also signaled that the lack of government policies to stimulate spending and growth will make it harder for the Fed to raise rates much above zero when it does start to tighten.
“They are beginning the normalization process; it’s meant to be gradual, the last thing they want is for the bond market to sell-off sharply,” said Myles Bradshaw, a London-based manager at Amundi, which oversees more than $1 trillion. Bradshaw said he’s “overweight” U.S. debt due in 10 to 30 years.
Traders are pricing in between two and three rate increases in 2016 following the one expected this month, putting the effective rate at 0.77 percent by year-end.
Not everyone is so sure Treasuries are a good investment. Steady gains in the labor market will help propel economic growth, lead to higher rates and make higher-yielding assets more attractive, according to Jennifer Vail, head of fixed-income research at U.S. Bank Wealth Management, which oversees $127 billion.
“Folks that favor risk will perform better than those that favor safety,” she said.
Stuart Sparks, an interest-rate strategist at Deutsche Bank AG, sees the greater risks to the economy and worries the Fed is moving too soon. That has the potential to upend the current recovery, spur even more demand for Treasuries and cause the yield curve to invert.
In the past week, signs of increasing stress in credit markets emerged as a swoon in junk bonds prompted Third Avenue Management to freeze redemptions from one of its mutual funds.
“The Fed could effectively lock us into a low-growth, low-inflation, low-interest-rate equilibrium,” he said.