In our last post, we discussed the recent decline in short-term interest rates and how different portions of the Treasury curve have performed before and after the FOMC begins to lower the Federal Funds Rate. This week, we will expand the discussion to touch upon how various fixed income sectors perform versus the Bloomberg Barclays Aggregate Index (Agg) before and after the FOMC begins to lower the Federal Funds Rate.
We evaluated the same time periods discussed in our last post; twelve months prior to the FOMC decision to lower the Federal Funds Rate in September 1998, January 2001, and September 2007. In each of those time periods, we looked at how the Treasury, investment grade credit, and high yield credit sectors performed versus the Agg twelve, six, three, and one month prior to the first reduction in the Federal Funds Rate. We also looked at how the emerging market sovereign sector performed. Based on the median returns over these time periods, the broad takeaways are that longer duration Treasuries outperform the Agg and shorter duration Treasuries underperform prior to reductions in the Federal Funds Rate. In the corporate credit sector, investment grade and high yield tend to underperform the Agg, with longer duration maturities outperforming shorter and investment grade outperforming high yield. Emerging market sovereign performance tended to be positive on a median basis, however, the performance was mostly driven by the 1998-1999 time period. The majority of the global economic and market problems in 1998 were based in the emerging markets (Asian currency issues and Russian sovereign debt default). Emerging market sovereign debt underperformed the Agg by 36-25% twelve to three months prior to a reduction in the Federal Funds rate in September of 1998.
In the last twelve months, a similar pattern has developed in the Treasury market, with longer duration maturities outperforming the Agg, while short duration maturities have underperformed. In the corporate credit sector, a different pattern has emerged, with corporate credit outperforming the Agg. Longer duration maturities have continued the trend of outperforming shorter duration and investment grade has outperformed high yield. Emerging market sovereign debt has performed better than prior periods leading up to reductions in the Federal Funds Rate. The performance of credit risk sectors in the recent twelve-month period has been better than historical averages, which likely reflects the reduction in Treasury interest rates (positive interest rate duration) without the typical increase in credit spreads (negative credit duration) observed in prior periods leading up to reductions in the Federal Funds Rate.
During the twelve months following the first reduction in the Federal Funds Rate, we find that shorter duration Treasuries tend to outperform the Agg, while longer duration maturities underperform. Treasuries, in general, tend to outperform the Agg in the first three months following the initial reduction in the Federal Funds Rate. From there, the performance of different Treasury durations seems to be dependent on the expected trajectory of the U.S. economy. Longer duration Treasuries performed better than shorter duration in the September 2007-2008 time period, as the outlook for economic growth and inflation continued to decline. In the corporate credit sector, performance tends to be positive, especially for shorter duration maturities. Again, this seems to be dependent on what is occurring during each time period as performance from September 2007-2008 was negative. Emerging market sovereign debt was positive, which mostly came from the recovery after the reduction in the Federal Funds Rate in September 1998.
While this is a limited data series of only three time periods and there are some unique elements to each time period, we believe the analysis does suggest that Treasuries tend to be positive contributors to performance in the first three months after the initial reduction in the Federal Funds Rate. Short to intermediate duration securities tend to perform well and corporate credit tends to respond positively in the first month following the initial reduction in the Federal Funds Rate. Beyond those similarities, it depends on what happens to the economic outlook, corporate profits, and how the FOMC responds to these changes. As always, we continue to monitor these developments and expect to provide updates on our thinking and positioning as they evolve.
Rank Dawson, CFA
Vice President, Research and Strategy
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.