Interest Rates: Are We Ready for Liftoff? | Lord Abbett
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Market View

Markets successfully weathered the 2013 “tapering” by the U.S. Federal Reserve and the accompanying rise in rates. How might they respond to a current-day replay?

Read time: 4 minutes

Bond investors’ “taper tantrum” in 2013 left an indelible impression on markets. As a result, the U.S. Federal Reserve (Fed) is treading carefully this time around as it considers reducing stimulative intervention in rates and mortgage markets. The expected date of a Fed tapering announcement (i.e., disclosure of plans to reduce the pace of bond purchases) has been pushed back from this summer to the end of the year.

The current situation raises two key questions. First, is the Fed being too cautious, and are markets too quick to draw the parallels between the two periods? Second, is the U.S. economy better positioned to withstand a tapering of asset purchases and higher short-term rates this time--and how will that translate to risk assets?

What Happened Last Time?

On May 22, 2013, then-Fed chairman Ben Bernanke gave an address to Congress where he stated, “If we see continued improvement [in U.S. economic conditions] and we have confidence that that’s going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases.” In the preceding Federal Open Market Committee (FOMC) meetings, some committee members were already expressing support for this plan, including now-chair Jerome Powell. There was only one dissenter to the unchanged policy action, Kansas City Fed President Esther George. So Bernanke’s statement came as a surprise—and markets don’t like surprises. Thus, the “tantrum.” The S&P 500 Index traded off 0.5% over the next week and the 10-year U.S. Treasury yield jumped from 1.93% to 2.17%, taking the Bloomberg Barclays U.S. Aggregate Bond Index down 0.8%. Despite this period of adjustment, the taper was largely successful from a U.S. equity market perspective, owing at least in part to the Fed famously qualifying its tapering and rate raising intentions as “data dependent.”  A year after the taper tantrum, the S&P 500 was up 13%.

 

Figure 1. Tallying the 2013 Taper’s Effect on Markets
Performance/yield of asset classes over the indicated periods following “tapering” remarks by U.S. Federal Reserve Chairman Bernanke on May 22, 2013

Source: Bloomberg. SPX=S&P 500 Index. AGG=Bloomberg Barclays U.S. Aggregate Bond Index. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

 

The impact on rates was, as usual, a little more complex. Despite an initial rise from 1.93% to 3.00%, the 10-year U.S. Treasury yield then plateaued for the next year and then retraced to all-time lows 20 months after Bernanke’s tapering comment. The rising part is simple enough-- the exit of a big, price-insensitive buyer from the market makes required yields go up. But then as short-term rates started to inch upward, the next phase of the Fed’s hawkish turn, economic growth stalled, and markets began to fear that rates would have to eventually come down again. Curtailment of credit in China and an oversupplied commodity market also weighed on U.S. growth, proving that economics is never a simple closed system.

In the end, 20 months after the first taper tantrum, stocks were up, bonds were up (long term rates were lower) and the Fed was able to stop new purchases of assets and navigate a return to meaningfully positive short-term rates.

What’s Happening Today?

It’s not surprising that always-adaptive markets have skipped to the punchline this time around. Though the Fed has been more careful in breaking the news of taper plans to the investing public, the market reaction mirrors the eventualities of 2013 through 2015: stocks up, bonds up (rates down). The Fed discussed tapering at its July 15-16, 2021, policy meeting; from July 16 through August 6, the S&P 500 has advanced 5% while the yield on the 10-year U.S. Treasury note fell from 1.57% to 1.29%.

But should the outcome be the same? Today’s U.S. economy is vastly different than the situation in May 2013.

 

Figure 2. How Does Today’s U.S. Economy Stack Up versus the Pre-2013 Taper Version?

Source: U.S. Federal Reserve Bank of St. Louis FRED database and Bloomberg. Data as of June 30, 2021. US GDP=U.S. gross domestic product. PCE CYoY=Year-over-year change in U.S. personal consumption expenditures. 5Yr Inflation Exp=5-Year Breakeven Inflation Rate. For illustrative purposes only
.

 

Based on the numbers in Figure 2 and continued strong guidance in 2021 second-quarter corporate earnings reports, we believe the economy is much better prepared for a cessation of quantitative easing (QE) and an eventual short-term rate liftoff this time around, and therefore should be able to support higher long-term rates as well. Strong demand for yield and technical positioning may cause some additional bumps along the road to higher rates.  In the end, though, negative real rates (nominal rates lower than inflation expectations) is an unnatural state. Figure 3 shows how unusual this level of inflation and low nominal rates is over history.  We think a resumption of traditional, market-based bond pricing should lead to positive risk premiums and higher nominal rates than the prevailing rate of inflation.

 

Figure 3. Current Levels of U.S. Inflation and Bond Yields Are in an Unusual Place
Month-end figures for 10-year U.S. Treasury note yield and 12-month rate of U.S. Consumer Price Index, January 1962–June 2021

Source: U.S. Federal Reserve Bank of St. Louis FRED database. Data are latest available. Highlighted dot indicates monthly levels as of June 30, 2021. For illustrative purposes only.

 

Finally, the impact of an end to QE, higher rates, and a steeper yield curve on U.S. equities is an open question. As shown in Figure 1, equities performed well during the last tapering event, but starting valuations were much lower than today. Ultimately, exceptional corporate profit margins and revenue growth have justified higher valuations among U.S. equities even as rates have risen off their lows. Growth stocks are often singled out as vulnerable to higher rates because of their longer-tailed earnings. We’ve noted that this “equity duration” concept is not reflected in past returns of growth and value stocks during periods of rising rates. It’s important to remember that higher rates generally accompany higher growth, so the impact on equity valuations is more nuanced than just discounting an earnings stream at a more punitive rate.

Investors can learn from history, but circumstances in any two given periods are rarely identical and we think that is the case today. We believe strong U.S. economic growth makes today’s prospective Fed taper a much easier proposition for markets than the 2013 taper, which itself turned out to be a brief interruption in a longer-term bull market for risk assets.

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 

The credit quality of fixed income securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

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Please consult your investment professional for additional information concerning your specific situation.

Glossary and Index Definitions

The U.S. Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.

Equity duration refers to the sensitivity of equity prices to changes in interest rates.

The 5-year, 5-year forward inflation expectation rate is a measure of expected inflation (on average) over the five-year period that begins five years from today.

Gross Domestic Product (GDP): The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The U.S. Personal Consumption Expenditure price index (PCE), also referred to as the PCE deflator, is a United States-wide indicator of the average increase in prices for all domestic personal consumption. It is benchmarked to a base of 2009 = 100. Using a variety of data including U.S. Consumer Price Index and Producer Price Index prices, it is derived from personal consumption expenditures, the largest component of U.S. gross domestic product in the U.S. Bureau of Economic Analysis’ National Income and Product Accounts report

Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.

The risk premium is the rate of return on an investment over and above the risk-free or guaranteed rate of return. 

Taper tantrum is a term popularly used to describe the 2013 increase in U.S. Treasury yields which resulted from the U.S. Federal Reserve's use of tapering to gradually reduce the amount of monetary stimulus in the economy.

The TIPS/Treasury breakeven rate (five-year inflation expectation rate) is calculated as the difference between the five-year U.S. Treasury rate and the five-year U.S. Treasury inflation-indexed security rate. 

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved.  

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