Financial Education | 9 May, 2018

Impact of official rates on long-term treasury bonds

Joaquín González Portfolio Manager

Investors usually believe that buying long-term US treasury bonds during a period of official rate hikes by the Federal Reserve is an unsuitable alternative. However, this supposition may not be completely true. Financial education with BBVA in Switzerland.

To discuss this further, we should consider the following variables, which can be summarised briefly as follows:

  • Official rates: the main monetary policy instrument used by a central bank (in this case the US Federal Reserve) to regulate the economic cycle, inflation and even the under- or overvaluation of assets (stock market, property, corporate bonds, etc.).
  • Rates (IRR) offered by 10-year US treasury bonds: these reflect the long-term, grosso modo, nominal growth (real growth plus inflation) of the United States’ economy.

Having included these variables, their implications can be analysed in chart 1:

  • In 1999, the Federal Reserve initiated a series of official interest rate rises that concluded in the first half of 2000, with a total hike of 1.75% (from 4.75% to 6.5%). However, during this period the yields (IRR) offered by 10-year treasury bonds remained virtually unchanged; the highest yield was even obtained in January 2000 before the cycle of rates increases had been completed. As a result, investors buying 10-year treasuries the very day before the first rate hike (25 June 1999) obtained a return of close to 6% over the next ten years (when the bond expired), while investors holding their investments in three-month treasury bills (which show little price sensitivity to movements in interest rates) obtained an annual return of 3% (almost half) in the same period.

 

  • In 2004, the Federal Reserve embarked on another cycle of official rate increases that ended in 2006. This time, official rates were hiked by 4.25% (from 1% to 5.25%) and the return offered by 10-year treasury bonds remained practically unchanged. Investors buying 10-year treasuries the day before the first rate hike (2 July 2004) obtained a significantly higher return over the next ten years than the return obtained by investors in three-month treasury bills during the same period. Specifically, the former obtained an annual return of close of 4.75%, almost three times that obtained by the latter (1.5%).

 

  • We are currently immersed in another monetary adjustment process that started in December 2015 and during this period official rates have risen from 0.25% to 1.75% (1.5%), while the ten-year bond yield has increased from 2.4% to 3% (0.6%). The Federal Reserve’s target is to put official rates at 3.4% at the end of 2020, which means that even if the US economy remains strong over the next two years and is able to withstand a further hike of almost 1.75%, the IRR offered by the ten-year bond (3%) would reach only 0.4% of this target level. Therefore, in our opinion, a conservative long-term investor prepared to tolerate moderate volatility could consider investing in long-term US treasury bonds as three-month treasury bills (no risk) and bank deposits would potentially offer an annual return of less than this 3% over the next ten years.

Why? The Federal Reserve increases official interest rates as a form of monetary hardening that at the same time reduces potential future economic growth (the more rate hikes, the less future economic growth). Therefore, as the return offered by 10-year US treasury bonds is more closely linked to this growth, a point is reached where the market starts to factor in a significant downturn in the economic cycle and this is when the yields on 10-year treasury bonds start to stabilise and subsequently fall, producing an increase in asset prices.

 

Chart 1. Interest rates (IRR) offered by US 10-year treasury bonds (top) and official interest rates (bottom)