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The Federal Reserve building in Washington.
Stefani Reynolds/AFP/Getty Images
A “hawkish pause” at the Federal Reserve’s September policy meeting has pushed bond yields to 17-year highs, as investors accept a higher-for-longer interest rate stance. Whether or not they have further to rise in the coming months, locking in today’s yields on offer is a good move.
The yield on the two-year U.S. Treasury note traded near 5.2% on Thursday, up 1.4 percentage points since May to its highest level since 2006. The 10-year Treasury note yield is at a 16-year high, near 4.5%. Yields have moved dramatically higher since 2020, when the Fed cut interest rates to near zero and the Covid-19 pandemic pushed investors into safer assets like Treasuries, causing prices to rise and dampening yields.
Ongoing economic strength and a tight labor market are contributing to lasting inflationary pressures in the U.S., keeping the Fed biased toward tightening longer into 2023 than most officials and economists had predicted. That means more potential downside for bond prices, which move inversely to yields, as the market prices in a higher peak in the federal-funds rate this year and fewer cuts in 2024.
It isn’t just a U.S. phenomenon. Global monetary policy rates from 38 different central banks are at their highest since 1995 when weighted by gross domestic product, according to Bespoke Investment Group.
With the economy going strong and inflation sticking around, interest rates won’t be heading back to zero anytime soon. In fact, they may still drift a bit higher in the coming weeks as the Fed delivers on another quarter-point rate hike this year.
A year from now, however, bond yields are likely to be meaningfully lower than today. Investors shouldn’t overthink trying to time the market exactly: Lock in those 4.5%-plus yields today, whether via Treasuries, bank certificates of deposit, or another structured investment. You’ll get an attractive cash coupon and the potential for some capital appreciation in the coming years.
Progress on inflation and greater signs of slowing in the U.S. economy in 2024 will allow the Fed to back off—not necessarily by cutting the fed-funds rate right away, but at least giving room for officials to more definitively signal that they have reached peak rates for the cycle.
“As it becomes clear the Fed is done raising rates, a ‘green light’ comes on for pension funds and insurance companies to lock in bond yields that are competitive with the expected return from equities in the decade ahead,” wrote Ulf Lindahl, CEO of Currency Research Associates. “It will push yields lower.”
Historically, the 10-year yield has peaked within a couple of 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 abroad that central banks are at or nearing their peak rates of this cycle. The Bank of England opted not to increase its target on Thursday, surprising markets. The European Central Bank and the Swiss National Bank appear to be done hiking. Brazil and Poland have begun to cut interest rates from their recent peaks. All this has started a retreat in bond yields abroad.
“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. “However, history tells us that on average, the last hike of the cycle is around the time that yields are more likely to hit their highs than any other.”
The biggest move higher in bond yields in decades has counterintuitively coincided with a rally in the stock market in 2023 driven by expanding valuation multiples. Relative to bonds, stocks have rarely been pricier, even with a rosy outlook for earnings growth in the coming year.
There’s downside risk for stocks and upside potential for bond prices whichever way the economy goes. Higher-for-longer interest rates mean that valuation pressures on the stock market will persist. In the gloomier scenario of a weaker economy that prompts rate cuts, earnings are at risk of falling short of expectations.
That means there’s another benefit beyond 5% yields of adding more bonds to a portfolio today—diversification. For the first time in at least a decade, investors can get paid an attractive rate of return for adding some ballast to their portfolios. What’s not to like?
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com