Positioning Portfolios For The Next Tightening Cycle by Gordon Bowers, Columbia Threadneedle Investments

  • Credit is trading at much more attractive spread levels relative to past hiking cycles, reinforcing our view that credit risk can perform well following liftoff.
  • Opportunities may present themselves to add duration risk further out the curve while the potential pullback in the dollar could create an opening to add currency risk.
  • Performance of inflation risk is mixed, with underperformance accelerating throughout the tightening cycle as the Fed lowers market expectations of future inflation.

With a rate hike by the Federal Reserve largely priced into the market, we decided to dust off our analysis of historical bond market returns after the Fed lifts off. As a precautionary note, the returns presented here consist of three hiking cycles (we exclude the 1997 rate hike as that cycle was cut short by the collapse of LTCM and the Russian debt default, among other global financial developments), and thus do not constitute what might be considered a statistically significant return population. However, it is still worth examining the data as we can draw some valuable conclusions.

Tightening Cycle

Source: Bloomberg and Barclays

Looking purely at six-month excess returns (returns in excess of duration-matched Treasuries) from the initial hike date, credit sectors performed relatively well during the initial phases of a tightening cycle while Treasuries did not. An exception is noted in the 2004 cycle when longer-term Treasuries posted gains due to both the well-communicated nature of rate hikes (in which the FOMC first introduced the “measured pace” language to the statement) and the global savings glut that drove down long-term rates (as referenced in Alan Greenspan’s “bond conundrum” comments).

The performance of inflation-protected securities was largely in line with expectations and reveals that the further along the Fed is in its tightening cycle, the worse the excess returns are to TIPS, as both realized and expected inflation generally decline.

Interesting, however, is the performance of the U.S. dollar. Historically, the USD strengthened prior to liftoff, before declining over following six months, indicating that foreign exchange markets price future rate differentials in advance. Additionally, contrary to conventional wisdom, even when the pace of U.S. rate hikes beat the forwards, the dollar failed to outperform. In all three of the past hiking cycles, the Fed raised rates at a faster pace than the market expected, and yet the dollar still lost ground, in some cases significantly.

Fast forward to recent returns and note the parallels between the last six months and the returns we typically see beginning six months after initial rate hikes (below). The similarities in these return patterns would suggest that the U.S. dollar, credit and Treasury inflation-protected securities are ahead of the Fed, or priced as though the Fed is well under way with its tightening campaign and the economy is starting to overheat. In contrast, short-duration Treasuries have yet to fully reprice to rising short-term rate expectations. There is no shortage of explanations for the low level of yields, from secular stagnation to the changing dynamics of global capital flows. But it is quite possible that with rates pinned to the floor for seven years, there is a significant segment of the investing population in the “show me” camp setting up for a further selloff in rates.

Tightening Cycle

Source: Bloomberg and Barclays

The similarity of these return series reinforces our view that the U.S. tightening cycle actually began with the taper tantrum in mid-2013, since which 10-year real yields have risen by 1.56% (from -0.917% to 0.641%). Significant dollar strength, a repricing of corporate credit markets, and declining inflation expectations are all consistent with this theme.

While excess returns to corporate bonds indicate the credit cycle is more advanced than the monetary policy cycle, we believe that recent spread or yield premium widening mostly compensates for what is likely to be a dovish hiking cycle over the next 12 months. Outside of troubled sectors such as energy and metals & mining and idiosyncratic stories, the risk to further spread sector weakness in the near term stems more from an accelerated pace of tightening tied to stronger economic data than it does to increased defaults. In corporate credit, the worst six-month excess returns from the date of liftoff occurred in 1994, when the initial pace of hikes was particularly violent and unexpected and the level of spreads too low to absorb the shock. However, if the current cycle plays out more like 2004 from the perspective of a well-telegraphed pace, current spreads offer a significant amount of cushion for the known risks in the market, including the deterioration in credit fundamentals and the rise in typical late-cycle “shareholder-friendly” behavior. In fact, spreads at the long end of the U.S. investment grade market are at levels historically associated with recessions.

Tightening Cycle

Source: Bloomberg and Barclays

What is notable about each of the past three hiking cycles is that the Fed surprised the market with more hikes than expected over the first 12 months of tightening. Indeed, the market may be setting itself up for a similar pattern this time, with the fed funds futures market pricing in just under three 25 basis point rate hikes by year-end 2016, versus the Fed’s own forecast of five hikes.

Examining these historical return series is a useful exercise from which we can derive four key takeaways:

  1. Credit has already widened out significantly ahead of the Fed and trades at much more attractive spread levels relative to past hiking cycles, reinforcing our view that credit risk can perform well following liftoff.
  2. After the initial selloff in Treasury duration, opportunities may present themselves to add duration risk further out the curve at higher yield levels, once Treasuries reprice to higher rate expectations.
  3. With the U.S. dollar already posting significant strength over the past 12 months, history suggests it is due for a pause once the Fed pulls the trigger, even if the pace of hikes surprises to the upside. Crowded positioning in the long dollar trade further supports a USD pullback and a potential opening to add currency risk.
  4. The performance of inflation risk is mixed, with underperformance accelerating throughout the tightening cycle as the Fed is credibly able to lower the market’s expectations of future inflation.

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