By Chris Iggo, CIO of AXA IM Core
Cast your mind back some 16 to 17 years. Between 29 June 2006 and 18 September 2007, the US Federal Reserve (Fed) kept the key Fed Funds overnight interest rate at 5.25%. Today, market expectations are for the Fed to keep the rate at its current level of 5.5% – where it has been since 26 July – until the end of the second quarter (Q2) of 2024.
The earlier period of rate stability lasted 15 months and in this cycle the expectation now is for the peak in rates to last for around 10 or 11 months. This plateau is being referred to in some quarters as the Table Mountain model, after South Africa’s famous flat-topped peak.
Globally, things were a little different. China was in full growth mode, with GDP growth of between 12% and 14% during the period. But there were also similarities. The dollar was strong. The US labour market was tight with unemployment below 5.0% until the second half of 2007 (hitting a low of 4.4% in December 2006, six months after interest rates hit their peak).
So, how did markets perform during that earlier period of ‘higher for longer’ interest rates?
The good news is that everything delivered positive returns, though there was a lot of dispersion. Strong growth expectations prevailed, helping equity markets – a significant difference from the situation today. Consistent with the positive returns from equities, bond returns were dominated by high yield markets. European government bonds, including UK gilts, posted positive returns but yields were in the 4%-5% range back then and most of the total return came from income. Shorter duration strategies did better, as yield curves were generally inverted, as they are today. Long duration bond assets only really started to perform towards the end of the period of high rates when investors started to speculate on the Fed cutting rates, which they did in Q3 2007 when there were signs of the US housing market starting to crack.
Also read: Finding a Sweet Spot for Local Emerging Market Debt
Lessons to be learned
The first lesson is that monetary policy can change quickly. Once the Fed did start to cut rates in 2007, it cut them quickly and aggressively.
High rates have helped short duration strategies in this current cycle. High yield has also been a strong performer, reflecting the reality that the economy has yet to show signs of responding materially to the monetary tightening already in place. Long duration bonds have underperformed. While broad-based signs of economic weakness remain scarce and inflation remains above target, the Fed is not likely to send any signal about pivoting away from its current stance. This is clear from public comments by Fed officials.
As such, short duration, high yield, and assets like leveraged loans should continue to perform and long duration assets might struggle. In 2007, long duration bonds only started to outperform high yield towards the end of the ‘higher for longer’ period. Bonds didn’t start outperforming equities until the Fed started easing. What came after was a huge outperformance of duration relative to risk assets as the world economy fell into the spiral of balance sheet collapse known now as the Global Financial Crisis.
The second lesson, then, is that monetary policy eventually works and central banks can’t really control how that plays out. The non-linearities of higher rates leading to a weaker housing market and a global financial crisis were not in the FOMC’s outlook in mid-2007. So, a negative outcome in this cycle cannot be ruled out. There is potentially a period ahead when risk assets will significantly underperform.
The outlook for markets now
There are rhymes in history. With short rates high and yield curves inverted, it is hard for longer-dated bonds to deliver much more than their yield. In 2006-2007, investment grade credit did a bit better than government bonds, but spreads were narrow in the first part of the ‘higher for longer’ period. A year into peak rates, spreads started to move quickly higher.
The level of credit spreads is higher today than it was in 2006-2007 so there is more chance of better credit returns for now, given the carry available relative to government bonds. This has been the case so far this year, with US and European investment grade outperforming relevant government bonds by 2%-3%. With spreads above underlying rates that are close to the overnight rate, short duration bonds look the best set to keep on performing for now.
The Fed kept a tightening bias for three years after starting the monetary cycle in mid-2004. If we follow a similar path and rates stay on hold until mid-2024, the recession that has been long awaited could come in late 2024 or early 2025 with risk assets going through a significant period of underperformance and long duration bonds delivering above-trend returns. This could be the last visit to Table Mountain for the global economy, for now at least.
So, those investors who think a recession is coming expect that inflation will fall, rates will be cut and risk assets will re-price. There is a rhyme.
