Markets & Economy

Markets took another sharp turn lower yesterday as the Federal Reserve’s (Fed) decision to raise interest rates by another 0.25% caught some investors off guard. Although the move was widely expected, some investors had been holding out hope for a less aggressive stance from the independent central bank.

Not long after the announcement, US equities began sinking, ultimately closing at a new low for the year. On a price basis, the S&P 500 is down 14.5% from its all-time high on September 20.

The volatility was felt in fixed income as well with long-dated bond yields quickly falling. The 30-year Treasury yield dropped back below 3%, a rapid descent from a high of ~3.4% early last month.

Since the Fed accelerated its rate hikes early last year, the Fed has been working steadily to ‘normalize’ monetary policy from the ultra-accommodative levels of the post-Global Financial Crisis recovery. The consistent rate hikes—yesterday was the ninth hike in the last three years—along with the ongoing shrinking of the Fed’s balance sheet has caused a tightening of financial conditions.

After so much monetary policy tightening, the question now is whether interest rates have reached their so-called ‘neutral’ level. The answer is seemingly ‘not yet.’

In its statement, the Federal Open Market Committee (FOMC) judged that “some further gradual increases” will be consistent with their objectives over the medium-term, and based on the Fed’s ‘dot plot’ forecast, policymakers anticipate two more rate hikes next year.

The bond market, however, seems to disagree with these projections. After the latest hike, markets are pricing in (i.e., expecting) almost no hikes for the entirety of next year, which is, in a sense, the bond market telling the Fed to stop the rate hikes.

At the same time, the shape of the yield curve should further worry policymakers. The yield curve is flattening, meaning that short-term bonds are yielding nearly the same as long-term bonds. In a normal environment, investors would expect more yield for a longer time commitment.

The yield curve further flattened yesterday as long-dated bond yields abruptly fell while short-dated yields held steady. Should long-term rates fall below short-term rates, inverting the yield curve, it would be an ominous sign for the economy. An inverted yield curve is a strong indicator of future economic stress.

An inverted yield curve would be an ominous sign for the economy

The Fed’s expectation for more rate hikes, versus the bond market’s expectation for none, highlights the disconnect between policymakers and investors. The split views could potentially lead to more yield curve flattening, and possibly even an inversion.

In this environment, we believe fixed income investors should maintain neutral duration positioning with a barbell approach. Barbell-structured portfolios perform best as the yield curve flattens, and unlike the typical, laddered fixed income portfolio, they overweight short- and long-dated bonds, while underweighting intermediate bonds (i.e., the ‘belly’ of the curve).