Asset returns in easing cycles

Steven Abrahams | August 2, 2024

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. This material does not constitute research.

With the Fed almost certain to start easing in the next few months, asset performance in the easing cycles since 1982 offers some useful lessons. First, duration or interest rate risk pays, with yields generally falling in eight out of the last nine easing cycles. Second, risk exposure pays when the Fed is responding to organic pressures on growth, including ones created by its own actions. And finally, risk does not pay when the Fed is responding to external shocks. As for the cycle ahead, both duration and risk look likely to ultimately add to performance.

Nine easing cycles since 1982, often for different reasons

Since 1982, after Paul Volcker thought he had severely wounded if not killed the inflation of the 1970s, the Fed has eased nine times (Exhibit 1). The reasons have varied from restoring fed funds to an estimate of neutral after an inflation fight to responding to recession to responding to crisis and the consequent risk of recession—the 1987 stock market crash, 9/11, the Global Financial Crisis and Covid being examples. The magnitude of the move in fed funds has ranged from 75 bp to 675 bp, and the days from start to finish from 50 to 1,190 (Exhibit 1). Twice the Fed has changed its mind and hiked once before quickly easing again—in the cycle of 1982 and in the cycle from late 1984 to late 1986. Although all easing in theory is in the service of price stability and full employment, the circumstances vary dramatically.

Exhibit 1: Nine Fed easing cycles since 1982

Source: Bloomberg, Santander US Capital Markets

Taking interest rates usually pays

Taking duration or interest rate risk as the Fed eases sounds like a straightforward way to make money, but it has not always worked out that way. In eight out of nine easing cycles, an index exposure to Treasury debt has rolled up positive annualized returns between 7.1% and 21.6% (Exhibit 2). But in 1998, after Russia defaulted on its debt and Long-Term Capital Management nearly collapsed, the Fed quickly cut 75 bp but an index exposure to Treasury debt nevertheless lost 1.9%.

Exhibit 2: An index exposure to Treasuries usually makes money—but not always

Source: Bloomberg, Santander US Capital Markets

Performance by risk asset varies widely

Returns on risk assets should track their key-rate durations and the changing shape of the yield curve in each easing cycle, so it is arguably more interesting to look at excess returns. Those should isolate the unique contributions of yield in excess of the Treasury curve, reinvestment of that excess, spread duration and changes in spread due to changing sector technicals and fundamentals. Daily excess return is broadly available since 2000, and the cumulative excess return of risk assets varies across the three easing cycles since 2000.

From December 2000 to June 2003

In the cycle from December 2000 to June 2003, the Fed broadly responded to the collapse of the late 1990s Internet Bubble and uncertainty following 9/11. All assets except high yield ultimately produced a cumulative positive excess return (Exhibit 3). But it was far from a straight path. Investment grade and high yield credit took significant hits after 9/11 and again in the second half of 2002 in parallel with a nearly 30% drop in the S&P 500. Both sectors rebounded toward the end of the cycle, with investment grade credit ending in positive territory. But agency MBS and private CMBS both produced positive cumulative excess return with a fraction of the volatility of corporate credit.

Exhibit 3: Excess returns in the easing cycle from Dec 2000 to Jun 2003

Source: Bloomberg, Santander US Capital Markets

From September 2007 to December 2008

In the cycle from September 2007 to December 2008, the Fed responded to the collapse of large parts of the US mortgage financing market in 2007 and 2008 along with the first decline in national home prices since the Great Depression. Over this period, no major risk asset delivered positive cumulative excess returns, although the volatility of excess returns varied significantly (Exhibit 4). Agency MBS showed the lowest volatility followed by investment grade corporate debt, high yield and private CMBS.

Exhibit 4: Excess returns in the easing cycle from Sep 2007 to Dec 2008

Source: Bloomberg, Santander US Capital Markets

From July 2019 to March 2020

In the cycle from July 2019 to March 2020, the Fed responded to two very different issues. In the cuts from July 2019 to November 2019, it responded to pressure on growth from a series of hikes from December 2015 through December 2018. Credit spreads had widened in the second half of 2018 as investors worried about slowing growth. After the Fed began this initial series of cuts, credit markets turned around and excess returns in risk assets began rising (Exhibit 5). Excess returns generally continued to rise—led by investment grade corporate debt and high yield—until Covid hit in early 2020 and the Fed quickly cut to nearly zero. With that last set of cuts, excess returns plunged as investors weighed the possibility of shuttered economies and severe economic damage from pandemic.

Exhibit 5: Excess returns in the easing cycle from Jul 2019 to Mar 2020

Source: Bloomberg, Santander US Capital Markets

Lessons learned

The nine Fed easing cycles since 1982 seem to offer a few broad lessons:

• Duration pays. In eight out of nine cycles since 1982, an indexed exposure to Treasury debt has delivered positive returns.
• Risk assets pay if the Fed is responding to organic economic developments such as corrections in equity markets in the early 2000s or the renormalizing of policy rates in 2019.
• Risk assets do not pay if the Fed is responding to external shock such as 9/11, the liquidity crisis of 2007 and 2008—although some might argue that crisis was organic—or the onset of pandemic in 2020

At this point, the series of cuts likely ahead for the Fed seems set to reward both duration and exposure to risk assets. The drop in fed funds expected by the market should bring the long end of the yield curve down, with 2-year rates approaching 3.0% by the end of 2025 and 10-year rates ending up somewhere between 3.50% and 3.75%. For now, the slowing of the economy seems orderly with clear signs of stress only in highly leveraged corporate balance sheets funded with floating-rate debt, in the office sector of commercial real estate and in the lowest tier of consumer income. Investment grade corporate and structured credit generally should do well.

But be on guard against external shock. In each easing cycle since 2000, the Fed has had to respond to something—9/11, liquidity crisis or Covid. In those instances, credit has had the most volatile response. Agency MBS could add ballast in those circumstances.

* * *

The view in rates

Still bullish on rates, both short and long. As of Friday, fed funds futures priced in an aggressive 118 bp of easing this year—a jump of more than 50 bp in a week after the July FOMC and a soft payroll report. The market is leaning toward a 50 bp cut in September, another 50 bp in November and 25 bp in December. The Fed says it still needs to be convinced that inflation is heading reliably back towards 2%. But if July comes in below 0.2% month-over-month, that could leave the Fed convinced. The report for July comes out August 14. As the Fed begins to cut, rates on the longer end of the yield curve should come down more than anticipated by forward rates.

Other key market levels:

• Fed RRP balances closed Friday at $338 billion. RRP balances bounced between $400 billion and $500 billion since the start of March, but the last three reading mark a new trend lower
• Setting on 3-month term SOFR closed Friday at 522 bp, down 3 bp in the last week.
• Further out the curve, the 2-year note closed Friday at 3.88%, down 51 bp in the last week. The 10-year note closed at 3.79%, down 42 bp in the last week.
• The Treasury yield curve closed Friday afternoon with 2s10s at -9, steeper by 9 bp in the last week. The 5s30s closed Friday at 49 bp, also steeper by 12 bp over the same period
• Breakeven 10-year inflation traded Friday at 206 bp, down 20 bp in the last week. The 10-year real rate finished the week at 173 bp, down 21 bp on the week.

The view in spreads

With the sudden drop in rates in the last week, implied volatility has spiked up as well. Credit still has momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risky and riskless assets.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 98 bp, wider by 5 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 134 bp, tighter by 8 bp on the week. Par 30-year MBS TOAS closed Friday at 29 bp, tighter by 2 bp on the week. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Auto loans show rising delinquencies that have as much to do with the price of used cars as it does the consumer balance sheet. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.