Fixed income: Lessons from past hiking cycles

 

Need to know We seek insight from analysing historical data to see how markets tend to react during rate hiking cycles, focusing on government bonds and corporate credit.  The impact of rate hikes on duration-exposed government bonds seems obvious on the surface, but there are interesting nuances when it comes to the shape of the yield curve, spreads and volatility. Our research suggests that initial periods of these cycles can be favourable for credit performance.

 

A shifting environment

In the face of elevated and sticky inflationary pressures, recent communication from the US Federal Reserve (the Fed) has emphasized the need to move away from the current ultra-accommodative monetary policy. This has guided investors toward a shift in the interest rate environment, as the Fed looks to begin a rate hiking cycle. Markets are currently pricing in around 125bp of hikes for 2022¹, in addition to speculation that the Fed will reduce its balance sheet. Risk assets have performed very well since the peak of the pandemic crisis. With the later stage of this cycle nearing, there are questions about whether this strong performance can continue.

In this research, we assess how markets have reacted historically to a rate hiking environment, using 75 years of US data. We split the observation period into “hiking”, “cutting” and “holding” environments, with 15 hiking cycles (Figure 1). Our analysis focuses on the two components of fixed-income returns: interest rate moves (duration) and credit spread moves. While every cycle is different and such an analysis is not an exact science, the results provide useful insights for Fixed Income asset allocation.

 

Figure 1: Federal Reserve rate cycles since post WW2 (1946-2021)

Source: Bloomberg, Global Financial Database, St Louis Federal Reserve, LOIM Calculations. Data are monthly. Hiking/cutting cycles commence from end of month of first hike.

 

Interest rate performance

The impact of interest rate hikes on duration-exposed government bonds seems obvious on the surface, but there are interesting nuances.

Intuition would suggest that hiking spurs increases across the whole yield curve in line with short-term rates, and that all duration segments suffer in hiking cycles. Indeed, Figure 2A shows that the 10Y yield has historically increased by an average of 84bps in the first 12 months of such periods, translating to negative total returns for government bonds. However, Figure 2B shows that the volatility of 10Y yield moves tends to be lower in hiking cycles than in other Fed regimes. This is probably because rate increases tend to run on a smoother trajectory, over longer periods than cutting cycles, and hence are more predictable. These cycles also tend to be anticipated well before the first hike, while catalysts for cutting, such as external shocks, typically occur unexpectedly. Removal of uncertainty reduces the likelihood of sharp repricing, lessening volatility.

 

Figure 2: Behaviour of 10Y yield in differing Fed regimes (1945-2022)

Source: Bloomberg, Global Financial Database, St Louis Federal Reserve, LOIM Calculations. Data are monthly. Hiking cycle commences in month 0. Hiking cycles as highlighted in Figure 1. Volatility figures are annualised.

 

However, the longer maturity segments of yield curves are influenced by growth prospects and less by short-term/central bank rates. As such, an increase in short-term rates, especially to higher levels than anticipated or above the neutral interest rate, could dampen the longer-term growth outlook and depress longer maturity yields. While Figure 2A shows that this is not enough to compensate for the increase in yields caused by rate hikes, it has important implications for the shape of the curve. In previous hiking cycles, the 10Y yield ultimately increased by less than the short-term rate, causing a flattening of the curve, as seen in figure 3². In addition, unlike the comparatively low volatility reflected in Figure 2B, Figure 3B shows more volatility in slope changes during hiking cycles than in holding regimes. This offers potential scope for nimble investors to exploit this flattening trend through tactical weightings of specific segments of the curve.

 

Figure 3: Change in 10Y short-term rate slope in differing Fed regimes (1945-2022)

Source: Bloomberg, Global Financial Database, St Louis Federal Reserve, LOIM Calculations. Data are monthly. Hiking cycle commences in month 0. Hiking cycles as highlighted in Figure 1. The slope is calculated as the difference between the 10-year yield and the central bank (short-term) rate.

 

Credit spread performance

The performance of credit through hiking cycles is somewhat less intuitive. On the surface, the resulting tighter financial conditions are unfavourable for risky assets, especially given increased refinancing costs. However, we must consider the overall state of markets as hiking cycles begin. The economy is usually coming out of a strong growth era supported by accommodative monetary policy. Conservative corporates are likely to have taken advantage of these conditions to build up cash or other buffers for more challenging times. Consequently, fundamentals tend to be strong from both a macro growth perspective and from a corporate balance sheet perspective, and defaults low.

Figure 4 suggests that, for credit spread or excess return performance, the strong fundamentals outweigh the tighter financial conditions, at least initially. In fact, Figure 4A shows that in every hiking cycle we analyse in this 75-year period, spreads tightened in the first eight months. Beyond this horizon, the unique circumstances of each cycle sees spread performance diverge. Although eight months is a somewhat arbitrary number and should be interpreted with caution, it highlights a consistent empirical pattern through 15 hiking cycles, covering a range of macroeconomic scenarios.

Observing volatility of spread changes through different regimes also allows us to draw noteworthy conclusions. Historically, spreads are more volatile in periods of central bank action than in periods of holding rates. However, in the initial six months of hiking cycles, the volatility is actually lower than in the other periods. Again, this is probably linked to the favourable fundamental conditions that dominate early on. Eventually, slower growth kicks in and spreads become more volatile. Nevertheless, the conclusions drawn from previous episodes show that the initial period of hiking cycles has been favourable for credit performance.

 

Figure 4: Change in US BBB Corporate credit spreads in differing Fed regimes (1945-2022)

Source: Bloomberg, Moody’s, Global Financial Database, St Louis Federal Reserve, LOIM Calculations. Data are monthly. Hiking cycle commences in month 0. Hiking cycles as highlighted in Figure 1. Spreads are for BBB US corporates. Volatility figures are annualised.

 

Allocation implications

No two rate hiking cycles are identical, each with their own unique set of macroeconomic and market conditions. However, we believe that this historical analysis can be helpful for allocation decisions across Fixed Income.

An overarching conclusion is that the first 6-12 months of hiking cycles historically favour a bias towards credit over rates. We suggest that this is because growth prospects remain strong, and sound balance sheets allow corporates to absorb the impact of tighter financing conditions. Duration assets are expected to suffer from increasing rates, but less so in longer-term maturity segments. This offers opportunities for active managers. We would also note that a continued allocation to government bonds remains prudent. They have excellent liquidity and diversification properties during periods of stress, and higher rates provide a buffer against exogenous growth shocks, as seen in the March 2020 Covid crisis.

Source

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