Insights on Navigating the Yield Curve and Market Volatility
RIDING THE YIELD CURVE
Throughout this past year, we have discussed our strategy of “Riding the Yield Curve.” This has meant that we have kept bonds and fixed-income securities near the short end of the yield curve in an effort to reduce interest rate risk in the portfolios from rising bond yields. It’s important to remember that bond yields and bond prices move in opposite directions. When interest rates or bond yields rise, bond prices fall.
When we started “riding the yield curve”, yields were about 2.5% on 3-year treasury notes. Our plan has been in place for some time, whereby we took maturing or called bonds, and rather than reinvesting the bonds in longer-dated maturities of 10 years or longer, we instead re-invested that money in three-to-five-year notes. Then about two years ago, we further shortened the maturities in fixed-income portfolios, preferring US Treasury bills with maturities not exceeding 12 months. These changes were implemented in anticipation of rising interest rates.
Rates certainly did rise and did so dramatically! In the last two years, the Federal Funds Rate has gone from 0.25% to 5.50%! Fortunately for our bond investors, most of the increase in yields has been seen in the one-to-three-year maturities or the short end of the yield curve. The yield on the long end has moved higher, also reflected in mortgage rates going from 3% to 7%, causing a nasty decline in the value of bonds.
The rise in bond yields caused one of the worst bond markets on record in 2022. This decline was what we have feared for many years. We protected our clients by shortening the bond maturities to reduce the amount of potential decline in portfolio value. We sacrificed some yield or income to preserve the client’s principal. This unfortunately has not been the case with banks, credit unions, and many investors thinking inflation was transitory, and the economy was stagnant, they paid the price.
TYPES OF YIELD CURVES
The yield curve is a graphic representation of the levels of interest rates over a number of years, usually 1-yr through 30 years.
Normal Yield Curve – In a normal yield curve, short-term yields are lower than long-term yields, indicating economic expansion. Investors demand higher yields for long-term bonds due to the risks of rising interest rates and inflation.
Inverted Yield Curve – An inverted yield curve has higher short-term yields compared to long-term yields. Often seen as a precursor to economic downturns, this curve suggests investors expect future interest rates to fall.
Flat Yield Curve – A flat yield curve occurs when short- and long-term yields are similar. This is usually seen during transitions between normal and inverted curves or under unconventional monetary policies.
We currently have an “inverted yield curve” and our “riding the yield curve” refers to us investing money in very short-term bills and then reinvesting the money as the bills mature at ever higher and higher yields until the short-term interest rates stop rising. At that time, we will extend the maturity of the portfolio to lock in higher yields and secure income with less potential temporary loss of market value from increasing interest rates. Our goal is to protect the principal, increase the income, and position fixed-income portfolios for potential capital gains if interest rates were to recede.
FED POLICY UPDATE
In a widely anticipated move, the Federal Reserve maintained the federal funds rate at 5.25%-5.50% at its most recent policy meeting. However, it was Fed Chairman Jerome Powell’s comments indicating that the central bank may keep interest rates higher for a prolonged period of time to counter inflation that caught many investors by surprise and led to a selloff in the markets. Powell stated, “Reducing inflation is likely to require a period of below-trend growth and some softening of labor conditions. We will keep rates restrictive until we are confident inflation is moving down to 2%.”
This is a topic that we have been discussing for months and we have consistently held our view that interest rates will have to be higher for longer to bring inflation down to the Fed’s stated 2% target. Many investors have just started to recalibrate their expectations for monetary policy and potential interest rate cuts, pushing expectations further into 2024.
This hawkish stance from the Fed resulted in a stronger U.S. dollar and higher Treasury yields, which had an adverse effect on equities. Elevated equity valuations are becoming increasingly difficult to justify, especially in tech-focused indices like the NASDAQ.
Yields on 10-year Treasury bonds have reached a 16-year high rising above 4.50% breaking above their October 2022 high of about 4.30%, affecting stocks and bonds.
The sudden spike in bond yields has put downward pressure on the stock market, specifically interest rate-sensitive sectors such as utilities and consumer staples.
Bonds are also under pressure with Vanguard’s Total Bond Market Fund, the largest bond fund, having wiped out its year-to-date returns, further dampening investor sentiment.
INFLATION
In recent months inflation has slowed from its torrid pace of 9% seen in 2022 to about 4% today. Much of the decline in inflation has coincided with a decline in oil prices. Oil is in everything, and its price is reflected in more than just energy costs. In addition to the transportation of goods and the heating of homes, oil is used in plastics, clothing, building products, asphalt, chemicals, etc. The recent resurgence in oil prices due to limited global supply could hinder the Fed’s ability to control inflation and simultaneously hamper economic growth. These factors are contributing to concerns about possible stagflation—a stagnant economy with high inflation.
Supply chain constraints, which added to inflationary pressure, have dramatically improved, but labor and wages have picked up the inflation banner. Unions are striking for higher wages and getting big increases. The United Auto Workers (UAW) have gone on strike as workers have requested a 42% increase in compensation!
We are nearing the peak in interest rates, but we haven’t reached it yet. We believe the recent commentary by the Fed and the subsequent move in treasury yields further supports this narrative. It’s not over yet, the Fed has only slowed the pace of inflation. Strong economic data has raised concerns that inflation may not fall back to the Fed’s 2% target, potentially leading to more rate hikes. An increase in unemployment will be needed and that may take more pressure from the Fed by increasing rates and withdrawing money from the economy.
FINAL THOUGHTS
We’ve covered the nuances of interest rates, our strategy for “Riding the Yield Curve,” the current state of Fed policy, and the impact of inflation on the financial markets. As we make our way through these fluctuating economic conditions, we remain vigilant in adapting to market changes to best serve your financial objectives. Your trust in us is invaluable, especially in such complex times, and we invite you to reach out should you have any questions.
Ryan J. Murphy, MSFP, CFP®, AIF®