Friday, May 26, 2023
- Both longer-term Treasury yields and short-term Treasury yields tend to decline during recessions, but the effect is larger and more consistent with short-term Treasuries.
- Over the last eight recessions, the median maximum yield decline for the 3-month Treasury was 2.82% and 1.14% for the 10-year Treasury.
- With an attractive yield compared to recent history and prospects of price appreciation if there were a recession, intermediate maturity Treasuries have a reasonable outlook on top of their potential diversification benefits if we were to see a downturn.
- The prospect of a decline in yields makes shorter maturity Treasuries less attractive, as investors may need to reinvest at much lower rates when bonds mature.
We are potentially at an important point of the economic cycle, both from the perspective recession risk and the end of a rate hiking cycle. LPL Research’s Asset Allocation Committee continues to be focused on what these potential changes might mean for investment performance.
Today we look at the historical relationship between bond yields and recessions. It’s worth cautioning that while the odds of a recession are elevated right now, it should not be treated as a lock. Also, every cycle is unique and there is some reason to believe there are factors that may mitigate the equity market impact of a potential recession were we to get one in the second half of the year. Among them:
- A meaningful amount of risk has already been priced in by last year’s market declines.
- Businesses and consumers are not as overextended as they are ahead of a typical recession.
- Recession risks have already been well signaled—a recession in the second half of the year would not be a surprise to anyone.
- Negative equity market sentiment is already extended by some important measures, a signal that tends to be bullish for equities.
- There is still some leftover post-pandemic pent-up demand on the services side.
- Changes to labor supply may make the job market somewhat less vulnerable to a recession, even if it is likely to take a meaningful hit
At the same time as the old saw often attributed to Mark Twain goes, history doesn’t repeat but it often rhymes. (There’s little evidence that Twain originated the quote, but if you have to guess where a quote comes from, after the Bible and Shakespeare, Twain isn’t a bad guess.)
Nevertheless, it still seems timely to review typical market behavior during recessions. We’ve been covering typical equity market behavior in a number of blogs over the course of 2023:
S&P 500 Performance Around Recessions, February 10, 2023
6 Things to Know About Stocks and Recessions, April 13, 2023
Stock Returns and Recessions Around Inflation Peaks, May 11, 2023
But we have yet to cover the bond market side. To that end, below is a table of the last eight recessions, the level of the 3-month and 10-year Treasury yield at the start of the recession, and the maximum decline.
There are some basic takeaways here but also some that aren’t so obvious.
- The maximum decline in the 10-year Treasury yield was smaller than the decline in the 3-month yield for all eight recessions, almost always by a wide margin, with the average decline in the 3-month greater by two full percentage points. The main driver of declines in 3-month yields is changes to Federal Reserve (Fed) policy, which can respond quickly to economic slowdowns. Forward-looking growth and economic expectations don’t change as dramatically.
- The greater decline in short-term Treasuries is also supported by a normalizing yield curve. Currently the yield curve is inverted (short-term rates are higher than long term). Inversion is not the natural state of things—investors usually demand more compensation (yield) for longer-term securities. But we do often see yield curve inversion before recessions as the Fed raises short-term rates to slow economic growth and fight inflation.
- Despite declines in the 3-month yield being significantly larger, the changes in both yields were highly correlated: larger declines in the Fed-driven 3-month Treasury yield tended to lead to larger declines in the 10-year Treasury yield. Based on history, you can roughly expect the maximum decline in the 10-year yield will be a little less than half the change in the 3-month yield.
- Even if the 10-year yield were to decline by only one percentage point in a recession, or a little less than average, price gains for a 10-year Treasury bond would still be meaningful. Based on current yields, a 1% decline in the 10-year Treasury yield would lead to roughly an 8.4% price gain (bond prices rise when yields fall). Of course, if Treasury yields instead climb 1% the potential price hit is about the same, but yields tend to fall rather than rise during a recession.
- Because of the large changes in the 3-month yield, “reinvestment risk” during recessions is high. That is, if you’re invested in a short-term Treasury, the odds are high that when you need to reinvest the funds, it will be at a substantially lower rate.
- It’s not in the chart, but 10-year yields tend to start rising prior to the end of a recession as growth expectations improve. Just as stocks tend to begin to reverse higher mid-recession, 10-year Treasury yields tend to reverse as well, although typically somewhat later than stocks. Given that reversal, the median yield decline from the start of the recession to the end is 0.43%.
- When yields were very low, the bar for stocks beating bonds was low as well. Higher bond yields raise the bar. We continue to favor stocks over bonds because of factors that might limit the market impact of a potential recession discussed above, but we also believe that fixed income’s defensive attributes have strengthened with elevated recession risk ahead.
- 10-year yields don’t always meaningfully decline during recessions and are generally most vulnerable to increasing when there’s a threat of rising inflation. The inflation trend continues to be toward inflation moving gradually toward the Fed’s 2% target, but there is some risk of inflation being stickier than expected.
- We no longer fear rate sensitivity (duration) and in fact have been neutral relative to our benchmark since October 2022.
- At the same time, we are somewhat more concerned about shorter-maturity bonds due to reinvestment risk. Memories of bond losses in 2022 might be keeping some investors from looking at intermediate-maturity bonds at a time when they are actually attractive.
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