Conventional wisdom would suggest that Fed easing cycles should be bullish for bonds, given the basic relationship according to which lower interest rates result in higher bond prices. However, a closer examination of the historical evidence reveals a more nuanced relationship. The chart below plots the path of the 10-year treasury yield around the start date of the last 8 Fed easing cycles going back to 1981, starting 12 months before the first rate cut of the cycle and ending 12 months after. The thick black line represents the average path across all eight cycles, while the yellow line represents the current path. From looking at this chart, a few things stand out:
- On average, the bulk of the 10-year treasury yield’s decline occurs before the Fed even begins cutting rates. The yield tends to peak around 3 months prior to the first rate cut, and declines by an average of 0.7% until shortly after the Fed’s first rate cut. Beyond this point, the 10-year treasury yield tends to stabilize and only sees a marginal further decline of about 0.4% starting at the 5th month mark of the easing cycle.
- Underneath the average, there is a high degree of variability across different Fed easing cycles. Only 3 out of 8 episodes saw the 10-year treasury yield end up lower after the first 12 months of the cycle. Another 3 episodes saw the 10-year yield slightly positive 12 months later but very close to being unchanged, while the remaining 2 saw the 10-year yield move meaningfully higher.
- Over the past 9 months, the 10-year treasury yield has followed a roughly similar pattern as the historical average.
Source: CW Advisors, Bloomberg, as of 9/12/2024
From examining more closely each of the past easing cycles, we find that two factors largely explain such high degree of variability in the path of the 10-year treasury yield across cycles:
- whether the economy ended up falling into recession within the first 12 months of the easing cycle, and
- whether the Fed ended up cutting rates more aggressively than the market expected at the onset of the easing cycle.
If our view of an economic soft landing comes to fruition, then the Fed should not need to overdeliver relative to current expectations, which means the 10-year yield may only see modest additional downside following the upcoming Fed rate cut. On the other hand, if growth ends up slowing down more than expected, Chairman Powell has already signaled that the Fed will not hesitate to ease aggressively. Under this scenario, history suggests yields could see significantly more downside, which would make bonds a good portfolio diversifier going forward.
Sauro Locatelli CFA, FRM®, SCR®
Director of Quantitative Research
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