Key points to remember
- The Federal Reserve’s interest rate hikes in 1980 sowed the seeds for a long-term recovery in bond markets.
- But the same prescription, repeated last year to tame inflation, hammered bond yields.
In the early 1980s, the Federal Reserve brought high inflation under control with economically painful interest rate hikes which, in turn, sowed the seeds for a 40-year bull market in fixed income securities.
The race finally started to end on March 17, 2022.
It was the day the Fed, after shielding the United States from pandemic catastrophe by holding its benchmark policy rate at an all-time low of 0-0.25% for two years, raised rates for the first times since 2018.
It hasn’t stopped yet. This week, the central bank raised its rate another 25 basis points to 4.75-5%, the highest since 2016, amid a battle to cut the highest and most persistent inflation since the Reagan administration.
Along the way, the financial losses multiplied, with the fixed income market being one of the biggest. From US Treasuries to investment grade corporate bonds, the past year has produced historic losses for bonds.
Genesis of a long-term rally
The dawn of the 1980s featured a mix of geopolitical and economic gloom: the Iranian hostage crisis, the Soviet Union’s invasion of Afghanistan, and a US economy beset by high inflation.
Fed Chairman Paul Volcker led the charge against rising prices. With annual inflation hitting 13.5%, the Fed in December 1980 essentially triggered a recession in the United States by pushing its rate to an almost unimaginable 19-20%.
The plan worked. Consumer inflation fell to 10.3% in 1981 and 6.1% in 1982. It only reached this level last year.
The Bond Bull runs for years
The bond market, albeit with a few hiccups, had a glorious run over the next four decades.
Unlike stocks, where bear and bull markets are defined by a 20% change in value, bond market prices do not have similarly established start and end values. Instead, bull bond markets simply reflect a prolonged downward trend in interest rates, and vice versa for a bear market.
Bond prices move inversely to yields, and yields began a long-term downward trend in late 1981. The benchmark 10-year U.S. Treasury yield – used to price large swathes of fixed-income securities – peaked on September 30 of the same year at a record high. -record time of 15.84%.
By August 1986, the 10-year yield had fallen below 7% as the Fed had been cutting rates steadily since the start of the decade. It rebounded to nearly 8% in the early 1990s, but fell below 5% after 9/11.
Seven years later, the Fed cut rates to historic lows during the global financial crisis and maintained accommodative monetary policy for much of the next decade. The 10-year yield fell to 1.43% in July 2012 and never exceeded 3.2% until last year.
During the pandemic, the Fed cut rates again. Simultaneously, additional extraordinary monetary and fiscal policy measures taken to protect the economy – including the Fed’s purchase of government bonds – pushed the 10-year yield to an all-time low of 0.52% in August 2020.
Here come the rate hikes
The 10-year yield rose as the pandemic subsided and the economy strengthened, but did not rise above 2% until the Fed telegraphed its rate hike campaign early of 2022.
The Fed’s first move in March pushed the 10-year rate to 2.48% that month. In June it was close to 3.5% and in October it reached 4.25%, almost tripling the level at which it started the year.
While bond yields have fallen as recession fears have grown, the 10-year yield remains about twice as high as it was a week and a half before the Fed’s first rate hike of the year. last. Meanwhile, the Fed indicated this week that it has steadily raised rates and has no plans to cut them this year.
Impact on the bond market
With rising rates, fixed income securities suffered historic losses.
US Treasuries and investment-grade corporate bonds lost 17.3% and 14.5% of their value, respectively, in 2022 – the largest single-year losses were recorded based on documents dating of 1928.
By comparison, Treasuries since 1980 had recorded double-digit annual percentage gains in 16 years, with investment-grade corporate bonds having done so 21 times during that period. Treasuries have recorded annual losses only seven times during this period, with only five annual losses recorded by higher quality companies.
The bond market has stabilized since the start of the year, with the Bloomberg Global Aggregate and US bond indices rising 2.7% and 3.1% respectively. But they are still down 8.2% and 4.8% since the Fed started raising rates last year.
Similarly, other fixed income securities suffered substantial losses.
The Bloomberg US Mortgage-Backed Securities (MBS) Index fell 12% last year before rebounding 3.4% since the start of the year, the Bloomberg Corporate High Yield Index fell 11% in 2022 (up 2.2% year-to-date) and the Bloomberg Municipal Bond Index was down 9% (up 2.1% year-to-date).
Inflation, of course, is a mortal enemy for fixed income investments. But rising interest rates too. With the latter deemed necessary to kill the former, bond investors are at least hoping their Fed-inflicted losses are worth it.
