Should We Worry About Rates?
This past week the Bureau of Labor Statistics released January’s Consumer Price Index (CPI), which showed prices rising +0.6% during the month and +7.5% over the past year. This outcome was higher than expected and resulted in another jump higher in interest rates. For the week the two-year Treasury ended 19 basis points, or 0.19%, higher finishing at 1.51%. The 10-year Treasury rose a more muted 3 basis points, to finish with a yield of 1.94%. As interest rates have risen, more so among shorter dated maturities than long, the yield curve has flattened. The difference in yields between 10-year and 2-year Treasuries, a common measure for the slope of the yield curve, is now the flattest it has been since August of 2020.
This week’s inflation data indicates that inflation is not trending down and makes a stronger case for the Federal Reserve to not only increase interest rates by a quarter of a percent at its next meeting in March but begs the question of whether the Fed should be hiking rates by a half a percent. Since higher interest rates cause bond prices to decline, it’s fair to expect more modest returns out of bonds in the near term. What we’ve seen in the first six weeks of the calendar year is an increase in interest rates in anticipation of future federal reserve action. While interest rates have been on the rise, the uptick has been more concentrated around the front end and belly of the yield curve, or 1-5 years in maturity. Thus far in 2022, two-year maturities have risen by 77 basis points or 0.77%. Five-year Treasury yields are up 59 basis points with 10-year yields up only 43 basis points.
More significant upward pressure on rates of short and intermediate maturities is not unusual during cycles where the Federal Reserve is hiking rates. The charts below highlight past Fed tightening cycles and the shapes of the yield curve during those episodes.
Source: Bloomberg
What is evident from these charts is that the impact of tighter policy out of the Fed tends to be most impactful on maturities five years or less. Hence you see much greater moves higher in shorter-term rates, yet in most of the past scenarios there was more modest upward pressure on yields of Treasuries 10-years or longer. Year-to-date we’ve seen a significant move already, and we believe four to five quarter point interest rate hikes are already priced into 2-year Treasuries. Hence should the Fed raise rates by a quarter of a percent in March, or even by a full percent by the end of July as one member of the Federal Reserve Open Market Committee suggested, we shouldn’t necessarily expect higher rates among Treasury bonds that are 1-3 years in maturity. Should the Fed indicate rates may go up by 2 to 3%, then there is likely to be room for more upward movements in rates.
Every tightening cycle is unique, and this cycle will be different than the past ones analyzed in the charts above. In particular, the highest level of inflation in 40 years has left the Fed focused on fighting inflation and they seem determined to what is necessary to tame it. As such, the past can help inform, but we do expect some differences and unknowns with this cycle.
Since bond prices fall when interest rates rise, in an environment like this, there are ways to proactively manage risk in bonds. Managing your portfolios duration, or sensitivity to movements in interest rates is one tool. Investing in fixed income securities that offer both safety and incremental yield to the portfolio is a way of incorporating a yield advantage that can add cushion against lower prices as rates rise. If you wish to learn more about how we have proactively positioned for a rising rate environment, speak to your Telemus advisor.
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The Consumer Price Index (CPI) measures the performance of US inflation (not seasonally adjusted) which is the rate of change of consumer goods prices. It measures of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for the U.S. and various geographic areas. Average price data for select utility, automotive fuel, and food items are also available. The data is from Bureau of Labor Statistics. The value of the current month CPI is estimated by the average value of the previous two months CPI.
An index is not a security in which an investment can be made, as they are unmanaged vehicles that serve as market indicators only and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. Advisory services are only offered to clients or prospective clients where Telemus and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Telemus unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.