The Big Idea
Debt performance in Fed tightening cycles
Steven Abrahams | January 28, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The prospect of Fed tightening and higher rates might seem to toll the bell for debt portfolio performance, but almost all major debt sectors have printed positive returns in the last two tightening cycles. Fed transparency and low volatility have helped, and that should broadly describe the cycle ahead. Some things are different this time, and the market is underestimating risk in the front end of the yield curve. But most longer rates and risk assets seem fairly priced.
The common features of tightening cycles, and the differences this time
The last four major tightening cycles all differ in their particulars, but all also have some common if not necessarily surprising features:
- Fed funds rise, moving up between 175 bp and 425 bp
- The 2-year Treasury rate rises, moving up between 136 bp and 296 bp
- The 10-year Treasury rate rises, moving up between 49 bp and 179 bp, although the magnitude has fallen in post-2000 cycles
- Implied volatility drops significantly in post-2000 cycles
- All debt sectors print positive returns in post-2000 cycles with leveraged credit outperforming
A few things should create a new set of particulars in the tightening cycle just ahead:
- Inflation and real GDP growth is higher than prior cycles
- The target neutral fed funds rate is lower at 2.50%
- Fed sensitivity to financial instability is clearer
At least relative to history, a few things are worth noting about current market pricing:
- Higher inflation and growth will likely make the Fed more aggressive than at least earlier post-2000 cycles. My colleague, Stephen Stanley, points out that inflation is getting carried along in significant part by rising home prices and owners’ equivalent rent, and that could add stubborn momentum to inflation. The New York Fed also finds that supply bottlenecks have helped drive goods inflation, and that may prove hard for monetary policy to tame. The Fed will likely move fed funds and 2-year rates more than it did in the 2015-2018 cycle and more than forward rates now anticipate.
- A low neutral fed funds rate and persistent liquidity should keep the 10-year rate at 2.50% or below, and the market is now pricing to that.
- Transparency in Fed policy and Fed sensitivity to asset performance and financial conditions should limit volatility and put a floor on debt performance, giving risk assets room to perform well.
A recap of the particulars of the last four Fed tightening cycles and the performance of major debt sectors follows.
The 1994-1995 cycle
This was one of the Fed’s most violent tightening cycles and least likely to be repeated by the current Fed. Fed funds moved 300 bp in 12 months, and both 2-year and 10-year rates moved higher at the fastest pace, too. The yield curve flattened. The cycle finished with implied volatility higher than where it started (Exhibit 1).
What may surprise many of today’s investors is that the Fed under Alan Greenspan gave no clue that this cycle was on the way. At that point, the market had to interpret monetary policy through the buying and selling of Treasury debt by the New York Fed’s Open Market Desk. The Federal Open Market Committee released its first statement ever after the first hike in this cycle on February 4, 1994. And it only said the Fed intended to “increase slightly the degree of pressure on reserve positions” and that this was “expected to be associated with a small increase in short-term money market interest rates.” There was no indication of pace, of whether the Fed saw financial conditions as loose or tight or of target rate. There was no forward guidance, no speeches by FOMC members and no press conferences.
With sharply higher rates across the curve and higher volatility, it is no surprise that most sectors of fixed income lost value through the cycle. ABS printed positive returns with low volatility largely because of its short duration and spread. MBS printed positive returns, too, because of its average nominal 30-year spread of 115 bp over the 7.5-year Treasury. Treasury debt and investment grade corporate debt, with long durations, lost money.
Exhibit 1: A violent 1994-1995 cycle pushed rates up and hurt debt performance
The 1999-2000 cycle
The Fed in this cycle tried to renormalize policy after easing in 1998 to counter the impact of Russia’s default of its debt and the collateral damage to the financial system from the collapse of Long-Term Capital Management. This cycle took less than 11 months and fed funds and 2- and 10-year rates moved up by roughly half the distance of the 1994-1995 cycle. The yield curve flattened. Volatility finished flat (Exhibit 2).
Although this cycle also happened on Greenspan’s watch, the FOMC had started releasing statements when ever its policy stance changed and offering guidance on target fed funds levels. In May 1999 it started releasing a statement after every meeting and by August started offering forward guidance on risks to policy. This cycle was more transparent than the last.
Until March of 2000, all sectors of fixed income had printed flat or positive returns through this cycle despite rising rates. But the bursting of the Internet bubble that month started to hit all sectors, with high yield and investment grade credit getting the worst. Those sectors ultimately printed negative returns over the cycle with all other sectors finishing positive.
Exhibit 2: Rates rose in 1999-2000 but debt returns rose before fading at the end
The 2004-2006 cycle
This last cycle that started under Alan Greenspan and ended under Ben Bernanke brought with it a full suite of Fed communication to prepare the market for tighter monetary policy. The Fed in May 2004 noted “policy accommodation can be removed at a pace that is likely to be measured.” Then the committee in June raised the federal funds rate by 25 bp and continued doing that at each of the subsequent 16 meetings. Over two years, fed funds moved up by 425 bp, the 2-year rate by 255 bp, the 10-year rate by 64 bp and volatility dropped by 27 points (Exhibit 3).
The sharp flattening of the yield curve during this cycle surprised the market and highlighted what Bernanke labelled a global savings glut that suppressed the rise in longer yields. The drop in arguably highlighted the impact of steady Fed communication about the path and outlook for Fed policy.
The steady pace of this cycle, the modest rise in longer rates and the decline in volatility allowed most major sectors of fixed income to print average annual returns between 2.5% and 3.0%. High yield, however, printed average annual returns of nearly 7.6% with only modest volatility, far outperforming other sectors.
Exhibit 3: A measured tightening 2004-2006 left all sectors with positive returns
The 2015-2018 cycle
This was the first cycle where the Fed had to lift off from nearly zero rates and start to reverse the effects of Quantitative Easing. Janet Yellen had the chair though this one. It included nearly all policy tools in play today including FOMC statements, forward guidance, speeches, press conferences, economic projections, interest on excess reserves, QE and others. Over nearly three years, fed funds moved up 225 bp, 2-year rates by 165 bp, 10-year rates by 49 bp and volatility declined 19 points.
QE arguably substituted for the global savings glut in this cycle by helping to keep the long end of the yield curve from rising rapidly. International investors still held nearly half of public Treasury debt at the start of this cycle.
The slow pace of this tightening cycle, the modest rise in rates and again the drop in volatility helped all sectors of fixed income finish with positive returns. Carry, reinvestment and spread tightening in risk assets helped offset the impact of rates. Credit turned in the strongest performance with high yielding print an 11.03% average annual return with high volatility leveraged loans printing an average 7.14% annual return with low volatility and investment grade corporate debt delivering a 4.77% average annual return with high volatility.
After tightening finished in December 2018, the Fed responded to rising market concern that the pace was too fast. Spreads on risk assets had started to widen and asset returns dropped. The Fed signaled that tightening was over, and risk assets rebounded.
Exhibit 4: The 2015-2018 cycle finished with leveraged credit far ahead
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The view in rates
The FOMC on January 26 left open the door to tightening faster than the 2015-2018 cycle, and that could involve a hike of 50 bp at some point. The market has repriced to that possibility, with 2-year rates moving up faster than 10-year rates.
The Fed’s RRP facility is closing Friday with balances near $1.615 trillion, toward the higher end of the range so far this year. With the RRP facility paying 5 bp, which is often better than repo rates lately, it is getting heavy action. RRP balances could also rise if bank deposit rates lag the rise in fed funds and other wholesale rates. Deposits could flow to money market funds and into RRP.
Settings on 3-month LIBOR have closed Friday at 29.9 bp, up sharply on the week. It has moved up steadily from 12 bp in early October as Fed hikes keep getting moved up in the market’s calendar. With markets that used to price to LIBOR now pricing to SOFR, it is worth noting that overnight SOFR has not moved in months off it’s 5 bp mark, so the LIBOR-to-ON SOFR spread keeps widening. Term 3-month SOFR has moved, however, from 5 bp in early October to close Friday at nearly 20 bp. Term SOFR is tracking LIBOR.
The 10-year note has finished the most recent session at 1.77%, up 1 bp on the week. The 10-year real rate finished the week at negative 69 bp, down 8 bp on the week.
The Treasury yield curve has finished its most recent session with 2s10s at 61 bp, flatter by 14 bp on the week, and 5s30s at 46 bp, flatter by 5 bp on the week. The curve should continue to flatten.
The view in spreads
Of the major spread markets, corporate and structured credit is likely to outperform, as it has since March 2020. However, that does not eliminate risk of wider spreads, especially as MBS widens. Corporates benefit from strong corporate fundamentals and from buyers not tied to Fed policy. The biggest buyers of credit include money managers, international investors and insurers while the only net buyers of MBS during pandemic have been the Fed and banks. Credit buyers continue to have investment demand.
MBS faces new pressure as the Fed considers a quick start to runoff. My colleague Brian Landy projects that new supply of MBS will run at $60 billion a month. He also estimates the Fed will need to allow runoff in MBS of more than $30 billion a month. Without the Fed or banks to take up an average of $90 billion in incremental supply supply, the burden would likely fall on mutual funds. Mutual funds do not have the capital to fully take up the slack.
MBS also faces pressure from new, higher loan limits on Fannie Mae and Freddie Mac MBS. Higher balances bring more negative convexity. Fed taper also reduces the amount of negatively convex loans filtered out of the TBA floating supply. The quality of TBA should erode this year, and spreads widen with it.
The view in credit
Credit fundamentals continue to look strong. Corporations have record earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. The consumer balance sheet now shows some of the lowest debt service on record as a percentage of disposal income. That reflects both low rates and government support during pandemic. Rising home prices and rising stock prices have both added to consumer net worth, also now at a record although not equally distributed across households. Consumers are also liquid, with near record amounts of cash in the bank. Strong credit fundamentals may explain some of the relatively stable spreads.