In today’s note, we comment on the recent rise in long-term interest rates and the danger to investors of over-reliance on recent experience in charting a course for the future.
Muscle Memory
The yield on the 30-year Treasury bond briefly exceeded 5% this week and has been trading at levels not seen since 2009. The upward trend now impossible to ignore, there’s no shortage of reasons cited in the financial press: the large US budget deficit, fewer foreign buyers due to falling exports and “de-dollarization” of global trade, the US Treasury’s excess stock of T-bills and the need for larger auctions on the long end, and so forth.
What’s harder to explain is why it’s taken us so long to get here. To be more specific, a set of heuristics (read Wall Street folklore) has become commonplace around the economic cycle and the yield curve, the relationship between the yields of Government bonds across the spectrum of maturities (e.g., 2-year notes vs 10-year bonds). In a healthy economy, investors expect to earn a term premium (a higher yield) for holding longer-dated bonds and accepting the risk of locking up their money relative to keeping it in a shorter-dated instrument. In his 1986 dissertation, eminent economist Campbell Harvey established the link between an “inversion” of the yield curve–when short rates are higher than long rates–and imminent recession. Since publication, this indicator had enjoyed a perfect predictive track record until the recent bout of Federal Reserve tightening, during which the term premium went negative for over two years with no recession in sight.
The playbook articulated in the financial media goes as follows: the Fed raises the short rates they control; the yield curve inverts, signaling their inevitable success in slowing the economy; longer-dated bonds sniff out an oncoming recession and (with it) the Fed’s eventual reversion to lower short rates and investors' flight to safety in risk-free long-dated Treasuries; yields of long-dated Treasuries fall.
The market for US debt includes large players–foreign central banks, commercial hedgers, and institutional investors with mandates to match their assets and liabilities–who are often price-insensitive buyers and sellers, so price movements need to be interpreted with care. Nevertheless, the heuristics (folklore, if you wish) and flows into bonds over the last two years strongly suggest that many market participants expected monetary policy to have a more rapid and decisive effect on economic growth and inflation than it has.
This sort of muscle memory is understandable in a world where the vast majority of investors have only experienced interest rates in long-term decline, with brief interruptions and quick reversions to trend orchestrated by an all-powerful and accommodating Federal Reserve. Muscle memory is also behind the wave of calls for a “soft landing” or no landing we’ve heard through the Summer. Economists are trained to understand that monetary policy acts on the real economy with “long and variable lags,” but muscle memory makes waiting for the impact difficult in the absence of confirming evidence. Investors have also been confounded by the headline performance of the most widely-followed stock market index, where a handful of expensive technology firms have masked weakness in the broader market.
Muscle memory has led many investors to expect adequate diversification in their portfolios when they only own stocks and bonds, and no assets that will perform well in inflationary environments or periods of interest rate volatility. Our muscles are only conditioned on the recent past. Inflation is an entirely new phenomenon for generations of US investors, but not to the annals of history. So-called “balanced” portfolios of stocks and bonds have become pervasive in the past few decades (during which they’ve enjoyed uncharacteristically strong performance), but a framework for portfolios with meaningful diversification--including resilience to changes in the inflationary environment--dates back to biblical times. Rather than rely on muscle memory to manage portfolios, we rely on the rich evidence history provides us to navigate financial conditions outside the range of most investors’ direct experience.
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