The Federal Reserve took a “hawkish pause” at its September policy meeting, raising bond yields to a 17-year high as investors welcomed higher long-term interest rates. Whether or not they have more additions in the coming months, locking in today’s product as a gift is a good move.
The two-year U.S. Treasury note traded at 5.2% on Thursday, up 1.4 percentage points from May. Yields have risen sharply since 2020, when the Fed cut interest rates to zero and the Covid-19 pandemic pushed investors into safer assets like Treasuries.
Continued economic strength and a tight labor market are contributing to persistent inflation in the U.S., making the Fed more likely to tighten through 2023 than most officials and economists had predicted. That means more potential declines in bond prices, which inversely shift to yields, with federal-funds levels peaking this year and smaller cuts in 2024.
It’s not just an American phenomenon. According to the Bespoke Investment Group, global monetary policy has been at the top of 38 different central banks since 1995, measured by GDP.
With the economy strengthening and inflation accelerating, interest rates won’t return to zero anytime soon. In fact, they could be slightly higher in the coming weeks when the Fed proposes another quarter-point hike this year.
A year from now, however, bond yields may mean less than they do today. Investors shouldn’t overthink trying to time the market right: lock in those 4.5%-plus yields today, in a Treasury, bank certificate of deposit or other structured investment. You will get an attractive cash coupon and potential for some capital appreciation in the coming years.
In the year Inflation and signs of a slowdown in the U.S. economy in 2024 could allow the Fed to pull back — not necessarily by cutting the federal funds rate immediately, but at least giving officials room to show they’re actually reaching higher levels. rates for the cycle.
“When it becomes clear that the Fed will raise rates, pension funds and insurance companies will get the ‘green light’ to lock in bond yields that are comparable to stock yields expected in ten years,” wrote CEO Ulf Lindahl. Currency Research Associates. “It keeps the product low.”
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Historically, the 10-year yield has peaked within two months of the Fed’s last rate hike, which could come at the Federal Open Market Committee’s November or December meetings.
There are signs from outside that central banks are at or approaching the peak of this cycle. The Bank of England chose not to raise its target on Thursday, surprising markets. The European Central Bank and the Swiss National Bank appear to have taken a hike. Brazil and Poland have already started to cut interest rates from their recent highs. All this has begun to retreat on foreign bond yields.
“We won’t know for some time whether this is the peak or not,” wrote Jim Reid, head of global fundamental credit strategy at Deutsche Bank. “But history tells us that on average, the last walk of the cycle is when it’s most likely to reach the highest point.”
Bond yields, the highest in decades, come in 2023 in contrast to a rally sparked by widening valuation multiples in the stock market. Relative to bonds, stocks are less expensive despite an optimistic outlook for earnings growth next year.
No matter which way the economy goes, there is a potential downside risk to stock and bond prices. High long-term interest rates mean that appreciation pressures on the stock market will continue. With a weak economy fueling deflation, earnings are at risk of falling below expectations.
This means there’s another benefit to adding more bonds to a portfolio today than a 5% yield—diversification. For the first time in at least a decade, investors can be paid attractive returns by adding some balls to their portfolios. What’s not to like?
Write to Nicholas Jasinski at [email protected]
