We were analyzing the relationship between FED fund rate and 10 years US treasury yield to understanding the impact of fed fund rate hike on yield curve slope. We chose to use FED fund rate instead of 2 year UST as we believe that FED fund rate is a controllable variable and it is used by FED to set interest rates for the various duration, while 2-year treasury rate is still decided by the market.
If we analyze the data for past 30 years we can see a consistent trend. In the past 30 years, there has been three major FED rate easing cycle which played out between 1987 -1990, 2000 -2003 and 2008-2010 as evident from the chart.
Similarly, there have been four episodes of rate hiking starting from 1982 -1987, 1994-2000, 2004-2006 and 2015 – present. Surprising the relationship between the 10 years and Fed fund rate has remained amazingly constant.
If we look at the given chart we can see that the maximum difference between 10 years - Fed fund rate is 3.3% -3.9% which happens when FED fund rates are lowered to support the economy.
Similarly, the yield curve spread gets inverted at the peak of rate hiking cycle. We saw this is 1989, 2000 and 2007 where the yield curve spread was negative from -0.58 to -1.02.
The current spread between 10 years UST yield and FED fund rate is at 1.41% which means that FED will have to increase rates by at least 1.75% to 2.0% for the spread to be negative by -0.5% or 10 year UST Yield will have to fall by 2% for the spread to be negative by -0.5% Or it will be a combination of both which will signal the end of current rate tightening cycle.
But before we go to forecasting the terminal fed fund rate let us first understand why this relationship has been consistent over different market cycles.
In the above diagram, we have plotted the FED fund rate on X-axis and 10 year UST yield on the Y-axis. We all know that FED reduces the rate to boost economic growth and to fight deflation which happens during the period of the economic crash. From the recent episodes, we saw that when fed fund rate hit 0.25%, the average yield of 10 years UST was 2.37% during that period. The question to my mind is that why didn’t 10-year yield fell much lower? I think that this happened because of the markets price in a long-term inflation expectation in long-term rates. Or in other words, even when the current inflation is very low, market assumes that over a period ten-year inflation will be higher and hence they demand a higher yield to compensate for longer-term inflation.
Similarly, when FED hikes rate to reduce inflation/slow down economic growth the FED fund rate moves above 10-year yield because markets price in that over next 10-year inflation will not be as high as it is now hence short-term rates move above longer-term rates as market do not factor a very high inflation component over longer-term period and the yield curve gets inverted which we saw in 1989, 2000 and 2007 where short-term rates were higher than longer-term yield.
The implication of this on bond investing
The investor should increase the duration of the portfolio if yield curve gets inverted which means that from then onwards FED fund rates will move lower and along with it longer-term interest rates will also move lower. Similarly, when the difference between 10year – FED is above 3% the investor should lower the duration of the portfolio as FED will start hiking rates and along with it, long-term interest rates will also move high.
Similarly, the investor should reduce the credit risk from the portfolio when yield curve gets inverted. Because as fed hikes rate to cool down the economy it increases interest cost, slows down economy and lot of lower rated companies will default on their bonds hence the credit risk in the market will go up.
While the investor should increase the credit risk in his portfolio when the difference between 10 years – FED rate is above 3% as it means that economic growth is anemic and disinflationary threat persist which will cause interest cost to go down and will be a prove more benign credit environment for lower graded companies.
Extrapolation in the current market fed fund rate hiking cycle
Assuming that the past relationship holds true, we can use this relationship to predict terminal fed fund rate or terminal 10 years US treasury yield. If I look at the long-term chart of 10 year UST yield the trend line resistance is at 3.5%
Assuming that 10-year yield doesn’t break this trend line it should peak out at 3.5%. and accordingly, if the yield curve will be inverted at the peak of the FED tightening cycle FED rate should be peak out around 3.5% to 3.75% to have inverted yield curve.
The current FED fund rate is around 1.5% and we are expecting FED to hike by at least 75 BPS in 2018 and another 75 BPS in 2019 which will bring FED fund rate to 3.0%. Assuming Fed hike rates by another 50 BPS in 2020 that should mark the end of the interest rate hike cycle and economic expansion. Depending on whether FED wants to expand the economic growth cycle or reduce it can expedite or delay the rate hikes.
If I extrapolate it a little further it also means that S&P500 should make a new high by that time and start a correction somewhere in 2020.
