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Déjà Vu

  • 29 September 2023 (5 min read)

Core bond yields are back to where they were in the first half of the first decade of the new millennium – and there are parallels with the situation in 2006-2007, the last time rates were kept high for a long period of time. But it’s the differences that are perhaps more important. Global growth is weaker, and confidence has been eroded` by the pandemic and energy shocks. Since the Federal Reserve (Fed) raised rates to what many believe will be the peak, markets have delivered negative returns, in contrast to what happened in 2006. That period ended badly - after more than three years of hawkish policy - with the global financial crisis in 2008. There might be a case for central banks to cut rates soon before it is too late.

Rule The World 

I was already working at AXA Investment Managers in 2007, the last time US Treasury yields were as high as they are today. Obviously, I didn’t know what was ahead – the near collapse of the global financial system – but it didn’t seem such a bad time. Rihanna’s “Umbrella” topped the UK pop charts in the spring, Take That reformed and Manchester United added their 16th English Football League title. Interest rates were at a peak in the US, the UK and the Eurozone, reflecting central banks’ desire to reverse the inflation caused by the global economic recovery that followed the dot-com recession. High bond yields meant decent income returns for fixed income investors. According to the ICE-Bank of America bond indices, annual income returns for US Treasury investors averaged around 4.75% between 2005 and 2007. Income returns for gilt investors were a little higher. Following the global financial crisis and the beginning of quantitative easing, bond yields were driven lower by central bank purchases and income returns fell to less than 2.5% per year for Treasuries from 2010 onwards.

Time to manage risk?

Both the Fed and the European Central Bank (ECB) kept interest rates at the then peak of the cycle for over a year – the Fed between June 2006 and September 2007 and the ECB between June 2007 and November 2008. There were similarities between the economic backdrop then and the one that prevails now. Inflation was too high for central banks; labour markets were tight and economic activity seemed – for a while at least – to be somewhat immune to the tightening of monetary conditions. The differences were that China’s economy was growing at more than 10% per year in the mid-2000s and there was a lot of leverage around that had propelled global house prices to dizzying levels. Today, the global economy continues to be somewhat impacted by the COVID-19 pandemic, at its height in 2020-2021, and the energy shock of 2022. It is not in great shape and markets are beginning to reflect that. There is a case for central banks acting soon – by cutting rates - to avoid what might be a negative outcome at the end of this cycle.

The pushback against that approach is, of course, that inflation remains too high. In 2006-2007 the Fed ultimately responded to weak growth and the financial crisis. Inflation accelerated again in 2008, before collapsing in 2009. Central banks can’t fine tune, but they can risk manage, and markets are suggesting that current policy settings are not optimal. Inflation breakevens are stable. Cutting rates today would signal active risk management - it would not by itself trigger an acceleration of inflation.

The peak is here, but losses are mounting

Today, markets are not performing well relative to the expectations of what would happen once central banks got to peak rates. Since the Fed raised the Fed Funds Rate to 5.25%-5.50% on 26 July, global equities have lost around 6% and US Treasuries have had a negative total return of 3.6%. Short-duration fixed income and high yield have been flat, and these were asset classes that performed well during the early phase of the peak rates period in 2006. To my knowledge, the only indices with a positive return since the Fed decision are US leveraged loans, European high yield, and UK index-linked bonds (which of course had their rate shock a year ago).

Three in a row?

We seem to be in a worse situation than in 2006-2007. Growth is weaker and consensus forecasts are for major economies to flirt with recession next year. There are questions over whether there has been enough of a tightening of monetary policy to return inflation to target. At the very least markets are resetting both their expectations of how long rates will remain this high and that rates, on average, will be higher going forward than they were during the 2010-2021 period. Both the growth backdrop and the expectations of rate resetting are undermining investment returns. Investor confidence is weak. Fixed income investors potentially face their third consecutive year of negative total returns.   

Curve dis-inversion is painful

For the first year of rates being at their peak in 2006-2007, 10-year Treasury yields traded in a range of 4.5% to 5.25%. That is slightly above where we are today but was consistent at the time with nominal GDP growth expectations. Total returns were 5.4%, driven by income. Today, the market really needs to stabilise to get a similar outcome. The problem in the near term is that the curve is flattening but it is a bearish flattening, coming from a very inverted position. Most of the adjustment is coming from higher 10-year yields with two-year yields rising too, reflecting the ‘new normal’ for medium-term interest rates. It was easier for bonds to perform well in 2006 because the yield curve was nowhere near as inverted as it has been this cycle.

Things change

After a year of rates being at 5.25% and three years after the Fed started hiking in 2004, risk sentiment started to crack in the summer of 2007. The housing market was falling, and mortgage delinquencies were rising. Treasuries and other long-duration bonds started to perform well from the middle of 2007. In the final three months before the Fed cut rates in September 2007, there were more and more signs of economic moderation and financial stress. Treasuries posted a total return of 4.5% with the over 10-year sector registering a gain of 6.7%. Meanwhile, high yield returns turned negative. Equity returns started to go negative and became deeply so for European markets as they were caught between the US heading into recession and the ECB keeping rates very restrictive. History rhyming?

Rhymes and echoes

The lessons from 2006-2007 are that the lags between the beginning of monetary tightening and the economy responding are long and unpredictable and that when policy does eventually pivot, it does so quickly. Even as late as the Federal Open Market Committee’s June 2007 meeting, the policymakers’ statement talked about inflation not moderating being the biggest risk, even as it was clear that the housing market was in big trouble. And finally, the lesson is that once markets turn, they turn violently. US equities lost 18% in the year after the September 2007 rate cut and a further 33% in the following six months. US 10-year yields fell from a peak of 5.3% in June 2007 to 2.1% in May 2009. They went on to another decade of trend decline before bottoming at 0.5% in 2020.  

A pivot to stabilise returns?

There are potential triggers to a big risk-off and bond rally market. The potential for a US government shutdown will impact aggregate demand, as well as business and household confidence. A downward spiral in activity could follow. The current tightening of financial conditions – higher bond yields, a tighter dollar and weaker stock prices – might accelerate the impact of the tightening in the pipeline on vulnerable parts of the economy. The labour market does not yet appear to be weakening – at least according to government figures – but the Fed cut rates in September 2007 when the unemployment rate was still very close to its cyclical low and non-farm payroll growth had continued to be positive (although subsequent revisions showed payrolls fell in July and August 2007).

Looking back at that earlier visit to Table Mountain it is hard not to conclude that this cycle could end with a sharp slowdown in growth and even a recession. Such a scenario would benefit assets perceived as ‘safe’ – even if the US does suffer another ratings downgrade – and high yield and equity markets could experience some significant losses. Moreover, unemployment would rise and living standards would be hit further. To avoid this outcome, there is an argument that the Fed should cut rates now and that such an action should be followed by cuts in Europe where growth is stalling, and in the UK, which will suffer if the US and Eurozone go into recession. There is enough in current market price action to suggest that things are not entirely alright and that monetary policy needs to pivot.

(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 27 September 2023). Past performance should not be seen as a guide to future returns.

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