Since the September Federal Open Market Committee (FOMC) meeting, bond yields with a maturity of 10 years or longer have risen sharply to levels not seen since 2007. The impact of this steep rise has been felt across almost all assets, with both bonds and equities selling off, as it’s a signal from bond markets that interest rates will stay higher for longer.

The precursor to the rise in bond yields, is that for over a year, many investors have been puzzled that central banks around the world have been increasing interest rates with little impact on local economies and equity markets. Employment in both the US and Australia remains close to 50-year lows (although gradually rising) despite one of the sharpest hiking cycles in history.

Investors in the early 1980s experienced peak US 10 year yields of 15.82%, with mortgage rates around the world even higher. US 10 year yields have recently approached 5%, however, it is important to note that the level of both household debt and government debt through the 80s was significantly lower than today. In the early 80s US debt to GDP was below 40% while today it sits at a whopping 130%, which means the recent sharp rise in yields could put more pressure on the economy today than it did through the 80s.

Why are advanced economies resilient?

The answer is in part due to the high level of fixed rate debt in the US, as well as ongoing fiscal spending by the US government. Many American households and companies locked in long term, low interest rate mortgages through the COVID-19 pandemic. Combine that with a better return on savings being delivered by rising interest rates and it has led a net stimulative response for segments of the economy.

The US government also continues to run the highest fiscal deficit compared to any other non-war era, an impact of which may be stickier inflation and a resilient economy, despite the Federal Reserve’s  efforts to clamp down on inflation and spending.

Can inflation fall without destroying growth?

Many suspect that either unemployment needs to rise, which will slow growth, or inflation will keep returning. Recent jobs data in the US came in much stronger than expected, and so did manufacturing PMI and retail sales (monthly measures of economic activity).

This has been a trend all year where we have seen economic data come in stronger than expected while inflation has fallen but remained elevated.  This combination has led to an increase in expectations that central banks may be able to bring down inflation without compromising growth. Sally Auld, Chief Investment Officer from JBWere, remains sceptical that this can be maintained, citing that history shows that this is merely a mirage and that eventually growth is likely to come down along with inflation.

Bond market signals

The US yield curve has been inverted (meaning bond yields on long term debt is less than shorter term instruments) since June 2022, a signal that typically proceeds a recession by 16 to 18 months. We are currently 17 months inverted with no recession in sight, partly due to the unusual nature of this cycle. More relevant to note is that recessions usually follow the steepening of the curve which we are seeing today. The rise in long end US yields is a phenomenon called a bear steeping in the yield curve, and today it reflects the fact the economy has been strong despite the 5.50% of rate hikes from the Federal Reserve. Before investors become concerned about a slowdown, they would need to see a meaningful rise in unemployment.

Typically, when we get a strong economic data point like the jobs data, long end yields often rise further given it is additional confirmation that the economy can handle higher rates for longer. Ironically this eventually may lead to a slowdown once US companies are required to refinance their debt at higher rates.

Usually when the yield curve is inverted, the re-steepening of the curve happens through a bull steepening, which is when the front end goes down rather than the long end going higher. Both signal different things, with the former signalling a potential Federal Reserve pivot and the latter signalling a higher for longer stance. Previous bear steepening occurred in the final quarter of 2018, 2007 and 2000. All three were followed by a sell off in equities and an eventual slowdown in growth.

Higher long end yields can be quite damaging to the US economy, that is because most borrowers, both corporate and households borrow based on long end rates rather than the overnight rate. Therefore, both bonds and equities have been selling off over the last few weeks.

What can investors do?

The question is how investors can position themselves in the face of rising yields? The answer is it depends on your view of the impact. The NAB economics team expects that both growth and inflation is likely to come down in 2024 and when they do, central banks around the world will need to start a cutting cycle which will lead to lower interest rates. Investors who agree that this is a likely outcome can turn to high quality corporate bonds to front run any potential rate cuts over the next few years. This will allow investors to take advantage of attractive bond yields  as well as benefit from the potential for an increase in bond prices once  rate cuts begin.

One thing that has become apparent is that both bonds and equities perform poorly when long end bond yields rise sharply, those who are looking to diversify further from a traditional 60/40 portfolio can look to allocate to investments that are uncorrelated to traditional asset classes. An option is to consider equity and FX tailored solutions.  These investments are used to target enhanced returns compared to most other income investments. These types of securities allow users to profit in a rising, flat or even falling market assuming the underlying security doesn’t decline more than a predetermined level. For investors who are interested in learning more about these tools along with other uncorrelated assets please reach out to your Investment Specialist.

This document contains general advice only and has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on the advice in this document, you should seek professional advice and consider whether it is appropriate for you in light of your objectives, financial situation and needs. JBWere Limited ABN 68 137 978 360 AFSL No. 341162 (JBWere) is a wholly owned subsidiaries of National Australia Bank Limited (NAB). JBWere’s obligations do not represent deposits or other liabilities of NAB. NAB does not guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer. You may be exposed to investment risk, including loss of income and principal invested. Information correct as at September 2023. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686. ©2023 JBWere Limited ABN 68 137 978 360 AFSL 341162.