The severity of the 2008 recession caused the Federal Reserve to lower short-term interest rates to near 0%. Seven years of extreme monetary accommodation facilitated the economy’s recovery resulting in a multi-year period of higher financial asset prices. Beginning in December 2015, the Fed reversed course and has been slowly raising the Fed Funds overnight borrowing rate. Over the past two years the rate has been bumped to just over 1.00%. An additional 0.25% hike is expected at the Fed’s December meeting. Investors are speculating about the ultimate magnitude of the Fed’s rate change and, by extension, the impact on intermediate-term and long-term interest rates. SMC FIM recognizes there is a common misconception in the marketplace that rising short-term interest rates bode similarly or worse for other maturity tenors along the yield curve. We provide historical evidence refuting the myth that a rise in short-term interest rates necessarily leads to negative performance for longer maturities. The graph below highlights the six periods during the past thirty years when the Fed has embarked on a tightening cycle by raising the Fed Funds rate. The shortest cycle lasted nine months and the longest cycle lasted two years. The current cycle, commencing December 16, 2015, is closing in on two years.
|Tightening Cycle||Months||Fed Funds Increase||Tightening Cycle |
|Tightening Cycle |
+/- 6 Months Performance**
|1. Dec 1986-Sep 1987||9||1.37%||-3.10%||15.15%|
|2. May 1988 - Feb 1989||9||3.25%||6.65%||19.60%|
|3. Feb 1994 - Feb 1995||12||3.00%||-0.76%||11.28%|
|4. Jun 1999 - May 2000||11||1.75%||-0.86%||7.02%|
|5. Jun 2004 - Jun 2006||24||4.25%||9.59%||14.33%|
|6. Dec 2015 - ?||22+||1.25%+||?||?|
This chart provides greater detail on past Fed tightening cycles. The fourth column, “Tightening Cycle Performance”, counters the misconception that rising short-term interest rates are inevitably a bad harbinger for longer-term municipal bond market performance. During two of the five tightening periods, the municipal bond market, as measured by the Bloomberg Barclays Municipal Bond Index, registered positive performance (periods #2 and #5). The average length of the five prior tightening cycles is just over one year, which in our opinion is too short of a timeframe to draw any meaningful conclusions. SMC FIM believes that investors need to be long-term focused. Focusing on short-term results can be detrimental if impulsive portfolio moves result. History makes a strong case for staying the course by staying invested. We advise the prudent investor to mind the forest (longer-term results) and avoid distraction by the trees (short-term deviations). We view market returns through a longer-term lens. Our analysis measures municipal market performance over a slightly longer period than the defined Fed tightening cycle. The time horizon utilized in SMC FIM’s preferred analysis begins six months before the actual commencement of Fed tightening and is also extended by an additional six months after the conclusion of the cycle (last column in the table). A total of twelve months was added to the tightening cycle timeframe. Observing performance over the additional twelve months in the preceding table provides a perspective worth noting. The municipal market registered significant positive returns during all five time periods. The average measurement period lasted just over two years. The worst market performance during any observed period was 7.02% (cycle #4), which lasted 23 months; the other four periods generated double-digit returns over time horizons ranging from 21 to 36 months. While the chapter on municipal market performance during the current tightening remains to be written, we note long-term market performance has been positive since the Fed started lifting rates nearly two years ago. From December 16, 2015, the date of the Fed’s first move, through October 31, 2017, the Index has returned 5.58%. We expect the fixed income market to climb a wall of worry throughout the current tightening cycle. However, history has proven that being under-allocated to this asset class could lead to sub-optimal investment performance, particularly from a longer perspective. So, how should municipal investors position themselves in the current interest rate environment? Based on the five previous cycles, it is our opinion that bonds positioned further out along the yield curve have proven to be less volatile and have also performed better than shorter maturity securities when the Fed is tightening.
The chart above refutes the common misconception about the behavior of longer maturity bonds during periods of tight monetary policy. Intermediate-term and long-term interest rates are generally influenced by factors other than Fed policy. While Fed Funds rate moves have led to a nearly corresponding change in short-term Treasury interest rates (2 Year), the longer end of the yield curve (30 Year) experienced about one-third of the interest movement of the short end (Fed Funds and 2 Year). Intermediate-term maturities (5 Year and 10 Year) also experienced less volatility. Of course, interest rate cycles are impacted by multiple factors. The Fed’s unprecedented response to the Great Recession might create its own special set of challenges for the current cycle. However, history suggests that the municipal market should not be adversely impacted over the long term. While investors may wish to maintain their fixed income investment allocations, due to recent and anticipated market changes, portfolios need to be continually reviewed and repositioned, if necessary, for performance optimization.
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
This commentary is provided solely for informational purposes and is neither an offer to sell nor a solicitation of an offer to purchase securities, any other investments or any other product sponsored or advised by SMC FIM, nor does it constitute an offer or a solicitation to otherwise provide investment advisory services. Such an offer or solicitation may be made only by the relevant documents for the relevant investment vehicle and/or investment program. This commentary does not constitute investment advice and is not, and may not be used as, a recommendation of any security, investment program or vehicle. It should not be assumed that any of the securities referred to herein were or will prove to be profitable. The views expressed in this commentary may not reflect the criteria employed by SMC FIM to evaluate investments or investment strategies.
Statements contained in this commentary that are not historic facts are based on current expectations, estimates, projections, opinions and beliefs of SMC FIM. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. Unless specified, any views reflected herein are those of SMC FIM and are subject to change without notice. SMC FIM is not under any obligation to update or keep current the information contained herein.
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