Fixed Income Update - Q3
U.S. fixed income markets experienced a very interesting third quarter. In August, the fixed income (bond) market experienced one of their strongest months of the year. Long-dated U.S. Treasuries, investment grade corporates, and U.S. high yield bonds outperformed for the month, extending year-to-date gains for these top-performing fixed income sectors. The strong performance up to that point in time was the favorable news on the inflation front, which helps longer-dated securities, and the expectation that the Federal reserve was to cut interest rates in September’s meeting.
The Fed did cut those rates by 0.50%, which to some was a surprise, while others were expecting the 50-basis point cut versus a 25-basis point cut. What transpired after the Fed cut is most important, as interest rates began to rise in the longer dated securities. By the end of September, we saw the 10-year end with a yield of 3.84% after beginning the quarter with a 3.78% and hitting a low of 3.61% on September 16, 2024. That is quite a roller coaster ride for a long-dated security. Of course, the opposite occurred in the short end of the curve as the Fed cut impacted the shorter dated securities more.
The question is how to strategically structure the fixed income portion of a portfolio to more directly benefit from Fed Funds rate cuts. Before we get to the solutions portion of our strategy, let us first provide some insights. There is a belief that whatever happens to the Fed Funds rate will then be passed along to the Treasury yield curve in a similar fashion. While directionally, the idea of the Fed Funds rate and UST yields moving up or down in tandem is somewhat accurate, the magnitude and timing of the changes tend to be less straightforward. The chart below provides some guidance on the expectations.
Fed Funds vs. UST 3-Mo, 2-Yr & 10-Yr Yields
Source: Bloomberg, as of 8/2/24.
Clearly, one begins with the Fed Funds target range, which represents overnight money. As a result, the closer the maturity is to Fed Funds, the more positive the correlation is going to be. The above graph highlights the relationship over the past 25 years between the mid-point of the Fed Funds target range and the UST 3-month T-bill, as well as the UST 2-Year and 10-Year note yields. The UST floating rate note could also be considered in this analysis given the fact that it “floats,” or is referenced to, the weekly UST 3-month T-bill auction.
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Thomas A. Edison
Therefore, given the above observation, one would expect the correlation between Fed Funds and the 3-month T-bill to be extraordinarily tight, and the relationship with the 2-Year note also positively correlated but to a lesser degree. The strong positive correlation begins to lessen considerably the further one goes out on the yield curve, as illustrated by the spread between Fed Funds and the UST 10-Year note. While directionally these two rates may move in a similar way, the correlation in yields will be noticeably lower when compared to maturities that are closer to Fed Funds.
Intuitively, this makes perfect sense. A maturity structure that is not too far removed from the Fed Funds rate, such as floating rate securities and the 3-month Treasury Bill, will be more closely linked to trends in overnight money (Fed rate hikes/cuts). However, as you continue to move away from the short maturity sector, other factors besides the Fed begin to come into play, such as inflation, economic activity and expectations, and investor demand for a “premium” due to longer “lock-in” of rates in securities with longer-term maturities, to name a few.
