2023's Best Asset Class: Long-Term Treasuries?
Our last fixed income insight focused on the 4 stages of the interest rate cycle. We conclude that we entered stage 3 at the end of the second quarter. Despite demonstrating that Treasury yields eventually tend to stabilize even as the Federal Reserve hikes aggressively - and outright decline during periods of earnings recession - many investors still don’t understand how RBA can be overweight long-term Treasuries given high inflation and our view that the Fed is nowhere close to a pivot*.
For all the concern about interest rates over the last several months, remember that on June 14th the 10-year yield hit what was then a cycle peak of 3.47%. The 10-year yield has stayed within 50bps of that June peak, apart from a few weeks. Although catching yields at their top would always be preferable, the unprecedented volatility and detachment from fundamentals have made that nearly impossible in 2022 (Chart 1).
Chart 1: Option-implied interest rate volatility as measured by MOVE Index, 50 days moving average (April 4, 1998 – November 18, 2022)
Source: Bloomberg, Richard Bernstein Advisors LLC, ICE BofA
Instead of trying to time the market, our process looks for inflection points that will drive medium to longer term performance. To this point, the times to really be worried about higher yields were in Stages 1 and 2 of the rate cycle (when we were very underweight duration) as the Fed tried to “hunt elephants with a pea shooter” and lost control of inflation expectations, growth and realized inflation (Chart 2). During this time, the 10-year yield increased 300bps from 0.5% on August 4th, 2020, to 3.5% on June 14th, 2022. Perhaps more astounding, 212bps of that increase, coinciding with a 15% loss in 7-10-year Treasuries, came in the 6 months between last December and June as the Fed hiked just 75bps and was still engaged in Quantitative Easing (QE).
* In this case we define a pivot as going from tight policy, including holding the Fed Funds Rate at a high level, to cuts.