The Fed Raises Rates 75 bps Amid Historical Levels of Yield Inversion

By TRG Advisors on September 22, 2022

The Fed Continues Aggressive Policy Tightening, Raises Rates 75 bps

The Fed unanimously increased the Fed Funds Rate by 75 bps in September’s FOMC meeting. Prior to this year, the last time the Fed hiked rates by 75 bps in a single session was November 1994. This year, the Fed has executed three consecutive 75 bps rate hikes, moving the Federal Funds rate target range from 0.0-0.25% at the start of the year to the current Federal Funds rate 3.0-3.25% – a total increase of 300 bps.

The Fed indicated they will continue to be aggressive, projecting a year-end 4.4% rate and 4.6% at 2023 year-end. The Fed then projects 3.9% in 2024, 2.9% in 2025 and 2.5% longer-run. The Fed forecasts just 4.4% unemployment in 2023 – up only slightly from today’s 3.6% unemployment rate. The dollar index also continues to rise sharply in light of Fed policy, hurting exporters and global U.S. companies. Growth is slowing, yet the labor market remains “out of balance,” and inflation is projected to remain elevated into 2025.

Investors should remember that the Fed got us into this situation, fueled by inaccurate projections. The Fed is still behind the curve. and the magnitude of their rate hikes clearly reflects that. The Fed’s
mandate remains maximum employment and price stability, and they remain “highly committed” to bringing down inflation – looking for “compelling evidence” that inflation is moving down. The Fed will
continue to be data-dependent in determining new policy adjustments. and they expect rates will remain at a restrictive level for some period of time.

While the Fed has tightened, the yield curve has shifted and twisted to reflect the projected economic implications of the tightening cycle. You may have heard the phrase, “What is the bond market telling us?,” due to the predictive powers of the bond market for inflation and the economy – useful in crafting an investment strategy across asset classes.

Today’s Yield Curve vs. A Normal Yield Curve

The Treasury yield curve reflects interest rates on Treasury fixed income securities across a range of maturities – traditionally, analysts focus on the 3-month through 30-year maturity range. The Fed
Funds rate is referenced as a baseline for all other interest rates in the fixed income market. Fixed income securities are priced with a premium spread against the Fed Funds rate. Premiums are priced
for added risk, which can stem from credit quality, maturity, liquidity, sector-specific or other forms of risk.

Using maturity risk as an example, bonds with longer maturity horizons are priced with higher interest rates on a normal yield curve. Today’s Treasury curve is flat and inverted at multiple maturities, reflecting the greater economic risk that’s further out and could result in lower future short-term interest rates. Spreads are also widening for corporate bonds at different credit qualities to reflect the rising risk environment. Lower quality bonds require higher interest rates to reward investors for the higher risk.

Chart 1: U.S. Treasury Yield Curve Shifting Higher and Inverting¹

Chart 2: 2s/10s Has Been Inverted Since July 5²

Chart 3: 3-Month/10-Year Spread Remains Near Lows³

Chart 4: 2-Year Yield Rising Near 4%, Comparison to Last Time at These Levels (2007)⁴

Chart 5: Rising Interest Creates Higher Unemployment, Rates Remain Historically Low⁵

Bond Market Performance

Shorter duration securities have outperformed longer duration securities this year as rates rise. Duration measures interest rate sensitivity, and in a rising rate environment, investors want shorter
duration exposure. In an environment with growing economic risk, investors also tend to seek safer assets with less spread risk. All else equal, safer fixed income (like U.S. Treasuries) assets have outperformed higher risk (like emerging market bonds), while shorter duration has outperformed longer duration year-to-date.

Chart 6: Select Fixed Income ETF Performance⁶

Higher Rates Impacting Other Asset Classes and Sectors

Similar to long duration bonds, growth equities tend to be more interest rate-sensitive than other equity styles (like value). Growth equities rely more heavily on debt to fuel growth, and higher interest
rates make growth more expensive, while slowing excess demand. Growth equities have underperformed throughout the Fed interest rate hiking cycle.

Financials, including banks, leverage a normal yield curve to lend at higher rates and sell loans at lower rates, called rolldown return. This is a source of income for financials, which benefit from a normal yield curve, but also higher rates in general, which provide greater income on loans.

The real estate market is impacted by higher rates in the form of slowing mortgage demand. Potential homebuyers are pushed away from the market by higher interest loans, and there’s been a serious
slowdown in the housing market. This has a multiplier effect for other sectors associated with new home expenses.

And lastly, investors with significant fixed income exposure may be looking for alternative income solutions, with less duration or spread risk. Floating rate notes, including TIPS, can provide some
protection, but are still exposed to duration risk. Opportunities within private credit and private real estate investments can provide uncorrelated fixed income returns. Further, dividend equities provide a regular income solution for investors.