Positioning Investments for Yield Curve Normalization

The yield curve is quite sensitive to both inflation and potential changes in policy rates by the central bank. A slight change in either inflation or policy rates or both can drive changes in bond yields. The aggressive interest rate hikes by the Federal Reserve (the Fed) in 2022 resulted in an inverted yield curve. Currently, investor sentiment for rate cuts is growing, which is helping to normalize the yield curve. Studying the historical rate-cut cycles, fixed income investors still have an open window to lock in better 10-year treasury yields before the rate cut starts. For equity markets, the performance through the rate-cutting cycle largely depends on the Fed’s ability to avert a recession. However, during the initial months after the rate cuts, the US equities have given moderate returns.

The inverted yield curve

The Fed began aggressively raising interest rates in 2022 to combat high inflation. Higher short-term interest rates led to higher yields on shorter-term Treasuries (2-year Treasury note) relative to longer-term ones (typically 10-year Treasury note), resulting in the inverted yield curve. In July 2022, the 2-year Treasury yields first exceeded those of 10-year Treasuries, and the difference reached a peak of 109 basis points (bps) in March 2023. The current yield curve has been inverted for more than 24 months, the longest period of an inverted curve in history. 

Moving towards Normalization of yield curve

The normalization of yield curve, commonly referred as upward sloping yield curve, happens when long-term bond yield exceeds those of shorter-term bonds. 

Normalisation occurs in two phases:

First Phase – without Fed intervention: The difference between the 10-year and 2-year treasury yield starts moving towards zero without the Fed intervention, as the market anticipates rate cuts. This phase is shorter and usually lasts for about four months. 

Second Phase – with Fed intervention: When the difference between 10-year and 2-year nears zero, the Fed starts cutting rate. The difference between 10-year and 2-year treasury yield becomes positive and start peaking as Fed continues to cut rates. Historically, in most normalisation episodes, the 2-year yield went down more than the 10-year yield.

The difference between 10-year and 2-year treasury yield moves towards zero or becomes positive before rate cuts

Since June 2024, the difference between 10-year and 2-year treasury yield has been declining. The difference declined from -49.6 bps on June 25, 2024, to -3.0 bps on September 3, 2024, increasing the probability of rate cuts. According to the CME Fed Watch tool, there is a 57% probability that the Fed will reduce its target federal funds rate by 25 bps in September from the current range of 5.25% to 5.50%. At the same time, there is a 43% chance the rate could drop by 50 bps.

Investment considerations for yield curve normalization and rate cuts

Fixed income

US treasuries are an attractive asset class during rate-cutting cycles and have given positive returns across almost all rate-cut cycles. 

In the past six rate-cut cycles going back to 1989, the 10-year treasury yield fell before the rate cuts due to growing sentiment of rate cut among the market participants. Post rate cuts, for the next 90 days, yields continued to fall but at a relatively slower pace. 

10-year treasury yields always falls before first rate cut; the decline slows once rate cut starts

In late-August, Fed chair Jerome Powell hinted towards a rate cut in September as inflation cooled and the job market slowed. As on September 3, 2024, 10-year treasury yield stood at 3.84%, down from the peak of 4.70% in April 2024. 

Fixed-income investors who missed the opportunity to capture attractive 10-year treasury yields can lock in the rate before the window closes. Moreover, in most rate-cut episodes; the 2-year yields went down more than the 10-year yield. Hence, investors can also target the 2-year yields to spread out the exposure. 

Equities

Historically, the performance of asset classes has varied based on the reasons behind declining interest rates. Equities generally do well during “soft landings” when the economy slows down gradually but avoids a full-blown recession, while they tend to underperform during “hard landings” where the economy enters a more severe downturn. Although historical trends offer valuable insights, not all rate-cutting cycles are the same.

S&P 500 Index performance during past Fed rate cuts

We look at the S&P 500 index to understand the impact of rate cut on US equities. During the initial months after the US Fed began cutting rates, the U.S. equities gave moderate returns. During these periods the S&P 500 index recorded an average 2% jump in its share price, one months after the Fed rate cuts, but in 4 out of the 7 instances the index gave a negative return in the first three months after the Fed rate cuts. However, the overall performance throughout the rate-cutting cycle largely depended on the Fed's ability to avert a recession.