By Douglas J. Peebles
Investors often ask us how they should think about bond markets in a time of rising yields. Are we facing a situation similar to 1994? Or worse, could it be like 1981, when five-year US Treasury yields soared to 15%? Our answer often surprises them: we don't think it's either.
We believe there's a better comparison that's much more recent. But first, let's dispel the 1981 and 1994 repeat rumors.
Runaway Inflation (1981) or Sudden Shock to the System (1994)
The driving characteristic of 1981 was double-digit inflation. In combating that, the federal funds rate soared toward 18%-20%. Today, questions around inflation mostly relate to the lack of it, rather than runaway levels of it.
Many investors claim 1994 as their reference point for the perils accompanying interest-rate hikes. Will improving US growth and falling unemployment trigger a repeat of 1994's rapid doubling of the fed funds rate from 3% to 6%? Probably not. Speed and surprise were key elements in 1994, and markets felt somewhat ambushed as the Fed rapidly fired about a half dozen rate increases after a long period of monetary calm.
Today, the Fed has taken great care to provide highly transparent communications about catalysts for future rate hikes as well as the likely extent and pace of them - none of which were present in the Fed's communications leading up to 1994's initial rate hike. And today's Fed intends to reduce its quantitative-easing programs before embarking on a normalization of rates, which may take several years to unfold. Which leads us to…
2003-2006: A Better Barometer for Today's Changes
While not a perfect match, we believe the June 2003-June 2006 period had some pertinent similarities to today: rates rose meaningfully, but slowly-and in response to improving growth over time. The fed funds rate began the 2003-2006 period at multi-decade lows (then 1%). Over the first year, 10-year US Treasury yields rose by roughly 100 basis points (bps). The Fed then increased rates by a total of 425 bps over the next two years, with 10-year US Treasury yields climbing another 100 bps.
Compare that to today. Both Fed and market expectations for the cycle suggest a very similar occurrence: an increase of nearly 350 bps in the fed funds rate and about 150 bps in the 10-year US Treasury yield. The big difference? This time, the Fed and markets expect the process to take even longer, approximately four to six years.
How did bond returns fare in the June 2003-June 2006 period? The 10-year US Treasury had an average annual return of -1.3% (-3.7% cumulative return), and the Barclays US Aggregate Index was up 1.5% annualized (4.6% cumulatively). Similarly, we'd expect benign, modestly positive core bond returns again if the same slow-and-steady scenario plays out - especially if the path is as lengthy as currently envisioned.
While the two periods share several key factors, some other elements of the story are different. We don't think they alter the basic resemblance, but they are important points for portfolio positioning today, and we'll discuss them soon.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.