Asset management

28 April 2014

Economist Insights The end of the beginning

Interest rates are going to rise eventually; what impact will that have on fixed income performance? The fact that everyone knows interest rates will rise means that it should already have been priced in. We look at how bonds have performed in previous rate hiking cycles, and show that what matters most for bonds is how surprised markets are by the rate hikes. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

1994 cycle

Everyone knows that interest rates are going to go up eventually. After all, the whole point of central banks forward guidance is to tell us when rates are going to go up. Plus, when rates are this low it is hard for them to go much lower. Everyone also knows that when interest rates go up, the yield on bonds goes up, and when yields go up prices go down. So surely everyone should be selling their bonds, right? Well, no. The key words here are everybody knows. If everyone knows that something is going to happen, it will already have been priced in. Rates are going to rise in the future? Incorporate that into the price of the bonds so that you are no worse off holding a 3-year bond than you would be holding cash at the expected path of central bank rates for the next three years. And there is another key word: expected. If central bank rates actually end up following the path that is expected today, then there will be no surprise losses (or gains). It is only when investors are surprised by the path of central bank rates that there are mark-to-market losses or gains. History shows that the performance of fixed income markets during a rate hiking cycle ultimately depends on whether the markets saw it coming. In February 1994, the Federal Reserve (Fed) famously caught the bond market completely unawares when it suddenly hiked interest rates. The resultant bond rout resulted in some of the worst performance for Treasuries that most bond managers had ever experienced. The expected path of 5-year Treasuries, known as the forward curve, that was being priced into the market just a month before was for only a slight rise in yields (see chart 1). Yields actually rose by almost 300 basis points within a year.

Chart 1: Some you see coming, some you dont Yield on 5-year US Treasuries around rate hiking cycles (%), actual and market expectations based on the forward path of 5y Treasuries 8 7 6 5 4 Feb-92 8 7 1999 cycle 6 5 4 3 Jun-97 6 5 2004 cycle 4 3 2 Jun-02 Actual Jun-98 Rate hiking cycle Jun-99 Jun-00 Jun-01 Jun-02

Rate hiking cycle Feb-93 Feb-94 Feb-95 Feb-96 Feb-97

Rate hiking cycle Jun-03 Jun-04 Forwards 1y earlier Jun-05 Jun-06 Jun-07 Forwards 1m earlier

Source: Bloomberg, UBS Global Asset Management

In 1999, a month before the first rate hike the bond market was pricing in 5-year yields to remain on hold. This does not mean that the market ruled out any rate increases; it is simply that the relatively high level of the 5-year yield already priced in some moderate rate hiking. Still, the market underestimated the speed. In sharp contrast, the market saw the 2004 rate hiking cycle coming and in fact was pleasantly surprised by the slow pace of increase relative to what was priced in a month before the first hike. Saying that the market predicted a rate hiking cycle a month before the first hike is not all that impressive: by that time the market has most of the same information as the Fed and will usually have had some warning from Fed statements (1994 being the exception). Looking at the forward curves a year before the first rate hike shows what was priced in before that information came to light. In the 1994 cycle the market was actually pricing in higher rates a year earlier than it was on the eve of the actual hike; the market had moved in the wrong direction so the losses were even more painful when they occurred. There was almost no change in rate expectations a year before the 1999 cycle. For the 2004 cycle there was a movement upward in rate expectations over the preceding year, but the surprise was more one of timing than direction and speed. These three cycles can be characterised as a large surprise, a small surprise and no surprise. Sure enough, the performance of Treasuries in each of these cycles was terrible, poor and decent, respectively. In the 2004 cycle Treasuries returned roughly the same as cash, which is what you would expect if the rate path is mostly priced in (chart 2). Underperformance of Treasuries was big in 1994 and significant in 1999. Credit underperformed similarly to Treasuries in the 1994 cycle. But in the 1999 cycle, both investment grade and high yield did much worse, reflecting the specific circumstances around the inverted shape of the yield curve. In the 2004 hiking cycle investment grade kept pace with Treasuries and stayed flat to cash, but high yield significantly outperformed. Unless the central bank has made a mistake, surprise rate hikes are usually in response to a surprise upswing in the economy, which is good for equities. There was little sign of this in 1994, suggesting the slowing impact of rate hikes was outweighing the economic strength. In the 1999 rate cycle equities significantly outperformed cash as theory suggests (but promptly lost about 30% when the tech bubble popped). In 2004 equities also outperformed, which is perhaps unusual because the hiking cycle was already priced in rather than being a response to surprisingly strong data. Perhaps there was simply an increase in risk appetite for other reasons; which would also explain the outperformance of high yield.

Chart 2: You have to see it coming Annualised outperformance of US asset classes versus cash during rate hiking cycles, % 8 6 4 2 0 -2 -4 -6 -8 -10 Treasuries Feb-94 to Mar-95 IG Credit Jun-99 to Jun-00 HY Credit S&P 500

Jun-04 to Jul-07

Source: Bank of America / Merrill Lynch, UBS Global Asset Management

The end of the beginning The lesson for todays investors is quite clear: fixed income assets perform better during rate hiking cycles when the rate cycle is widely predicted, and worse when it is a surprise. The 2004 cycle was predicted because the Fed was quite clear about its direction and also about the speed of hiking. If anything, the Fed is now trying to be clearer than ever before. By giving forward guidance and publishing its own projections the Fed has told the markets more than ever about its intentions. The next rate hiking cycle will probably be the most well-signalled in the Feds history. If the Fed does in fact hike exactly how it has indicated and how the market is pricing in (and there is not another crisis), then Treasuries should actually outperform cash because investors should receive a term premium for their Treasuries. Both investment grade and high yield should then earn more because of the risk premium over Treasuries. In this scenario, those who are worried about a sell-off in fixed income have missed it it already happened in 2013. The market moved from pricing in rate hikes sometime in the far future to the far more specific late 2015. Treasuries lost about 5% between February and May last year as the market priced in the new path. The question investors now need to ask themselves is whether they believe what is priced in. If you are optimistic about the economy and think the Fed will hike earlier or faster, then fixed income is not as attractive. If you are gloomier and think the Fed will not be able to raise rates as fast as what is priced in, then fixed income is more attractive.

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