Treasury Rates - September 2022
When it comes to the 10-year Treasury yield, what mattered more? Inflation, recessions, or corporate profit growth?
Parts of the economy are clearly slowing because of the higher interest rates and inflationary pressures. Typically, when this happens bonds are the place to seek shelter, especially Treasury securities. This is the logic of a balanced portfolio of 60% stocks and 40% bonds. When growth slows or risk appetites abates and stocks falter, the highest quality, lowest risk securities rise in value as interest rates decline. We have managed balanced portfolios for our clients for decades and they are broadly accepted as offering an attractive risk-adjusted returns over time. With that said, the inflation we are seeing today has not been experienced for 40 years, and it has already proven disruptive to many well-established expectations. The question posed above is something that we have been researching and discussing for months, so we wanted to provide some insight into how and why we have maintained a low exposure to fixed income in general and preferred to own bonds with the shortest duration or those least sensitive to higher future rates.
We must go back to the 1970’s and early 80’s to find a period where inflation was at similar levels as we have experienced in 2022. At that time, the Fed raised rates significantly in ’73, hiking into the recession of ’74, as inflation continued to climb well above the 10-year yield. Despite the recession, a decline in corporate profits, an eventual change of direction in Fed policy in mid ’74, and peaking inflation in early ’75, the 10-year yield did not decline until late ’75, when inflation fell below the yield.
The 10-year yield more closely tracked inflation in the late 70’s and 1980, when the Fed became very aggressive raising the fed funds rate above inflation. Again, despite the peak in inflation in 1980, the 10-year continued to climb as it “caught up” to inflation in late 1980 and continued to rise until September of 1981. However, in this period, the 10-year did move sideways and then declined during the twin recessions in the early 80’s. The fed funds rate and the 10-year remained well above inflation for several years after inflation cooled. While the fed funds rate was reduced a few times down to the level of inflation in the early 90’s and 2001, the 10-year only met back up with inflation in 2005.
From the beginning of 1979 through 1982, stocks rose, and bonds declined. The S&P 500 Index rose 27%, the Bloomberg US Aggregate Bond Index declined 12% and the ICE BofA US Treasury Bond Index (7-10 years) declined 5%. Most of the outperformance for equities occurred in the second half of that 4-year span, coinciding with the peak in inflation, but because rates did not follow inflation lower, fixed income did not see the same appreciation as stocks¹.
Today we have a similar situation to these periods with inflation well above the 10-year treasury rate, a Fed that is quickly responding, and growth slowing. While you would expect bonds and specifically Treasury securities to do well in a period of declining corporate profits or a recession, the precedent of the late 70’s/early 80’s would tell you differently.
In summary, based upon the historical comparison to the 1970-80’s, the relative level and direction of inflation seemed to matter most when it comes to the direction and level of the 10-year yield. We might be looking at a profit contraction or a recession and inflation might have peaked, but the 10-year treasury rate remains significantly below the level of inflation. This would argue for further upward pressure on interest rates and therefore longer dated bonds would not provide the relative protection that many would expect.
Tyler Pullen, CFA
Portfolio Manager
¹ The returns cited are from FactSet, based on the S&P 500 Index, the Bloomberg US Aggregate Index and the ICE BofA Treasury 7-10 year Index.