by (Bloomberg) — Investors who buy long-term bonds have history in their backs.
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For decades, government bonds with maturities of 10 years or more have consistently outperformed sectors with shorter maturities, immediately following the latest in a series of rate hikes by the Federal Reserve. On average, they achieved 10% returns for six months after Fed Funds rates peaked.
Of course, you only know afterwards whether a rate increase is the last. But investors have embraced the view that an expected quarter-point increase in the target range for the federal funds rate on July 26 will end the epic streak that began in March 2022. And studies by Bank of America Corp. and JPMorgan Chase & Co. have found that investors processing the price action have increased their exposure to long-term bonds.
“We like the idea of extending and adding duration at this point in the cycle,” said Nisha Patel, a general manager of SMA portfolio management at Parametric Portfolio Associates LLC. “Historically, during previous tightening cycles, yields have tended to fall” in the period between the last hike and the first rate cut, she said.
Bonds this week posted their biggest gains since March – when the failure of several regional banks unleashed demand for safe havens – after a report found consumer prices rose at their slowest pace in two years. Swap contracts that last week still had more than a 50% chance of another Fed rate hike after this month brought that down to about 20%, adding to bets on rate cuts next year.
The shift in sentiment caused a kneecap for the dollar, which took its biggest weekly loss since November. With the European Central Bank and other major monetary authorities expected to remain in tightening mode, more downside is likely in store for the greenback, according to ING Bank NV strategists.
For bonds, the largest yield movements occurred in short- and medium-term maturities, which express expectations for Fed policy. The five-year rate fell nearly 35 basis points, compared to just 13 basis points for the 30-year rate.
But long-term bonds’ greater price sensitivity to a given change in yield means investors can reap greater rewards. On average, Treasuries with maturities of 10 years or more have risen 10% in the six months following a peak in the Fed’s policy rate, compared to 6.5% for bonds with maturities between five and seven years and 3.7% for bonds with maturities of up to three years, according to data collected by Bloomberg. In 12 months, the longest-dated bonds returned 13%, outperforming other sectors.
“There is finally income to be made in the fixed income market,” BlackRock president Rob Kapito told analysts Friday, calling the higher yields a “remarkable shift” and a “once in a generation opportunity.”
As an end-of-cycle theme, it has proven more reliable than gambling on relative changes in yields like the one that occurred this week, when two- to five-year yields fell more than longer-term rates, yielding a steeper yield curve.
The spread between two-year and ten-year rates widened in the six months after the Fed ended a tightening cycle in December 2018, but narrowed after the end of a cycle in 2006.
“Long maturity at the end of the hiking cycle is a more consistent trade than the steeper, which is more dependent on a harder landing from the Fed,” Bank of America strategists, including Mark Cabana and Meghan Swiber, wrote in a note. .
A Bank of America investor survey conducted monthly since 2004 found that respondents had accumulated a record amount of interest rate risk relative to their benchmarks in June before falling slightly this month.
“I like maturity here,” said Eddy Vataru, a fixed income manager at Osterweis Capital Management. Inflation, which cooled to 3% last month, its 12th consecutive decline from a peak of 9.1% last year, has room to fall below 2%, he said.
Naturally, Fed policymakers remain wary. Their quarterly forecasts for policy rates published in June had a median expectation of two more hikes this year. Fed Governor Christopher Waller said Thursday he agrees, even after the latest inflation reading, as the labor market remains very robust.
Even if employment prompts the Fed to continue tightening past July, investors may turn to Treasury bills because yields are high enough to provide compelling protection against a potential recession, said Michael Franzese, chief of trading in fixed income for the New York based market. creator MCAP LLC.
“There are a lot of investors right now who want to take a chance and buy” if yields start to rise again, he said. “We may see a wave of new purchases coming in as government bonds are an asset that could very well grow for investors when the Fed eventually starts to cut.”
What to watch
–With help from Edward Bolingbroke.
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