What is the link between duration and monetary policy?

How does duration affect bond performance in different rate environments?

Duration, a measure of how sensitive bonds are to changes in interest rates, is an important metric for fixed-income investors to be aware of when considering how to position their bond allocation through different phases of the monetary policy cycle. 

As the economy slows and enters a contraction, central bankers typically will engage in expansionary monetary policy to foster economic growth. To do this, central banks often lower interest rates, helping to stimulate additional borrowing and spending. Given the inverse relationship between bond prices and yields, long duration bonds tend to outperform short-term bonds during this part of the monetary policy cycle as interest rates fall.

The opposite is true when rates are rising, with short duration bonds being well insulated from rising yields relative to longer duration bonds. Economic growth is typically strong during this part of the cycle, which can bring high inflation along with it. Although this inflation can eat into nominal returns, rising rates allow these short-term bonds to be reinvested at higher interest rates as these bonds mature. 

What is the yield curve?

The yield curve is another important concept for fixed-income investors. It reflects the relative differences in yields that bonds pay depending on their maturities—that is, the date after a bond’s issuance when the principal debt is to be repaid with interest.

Short-term interest rates are most sensitive to the decisions made by the U.S. Federal Reserve’s (Fed’s) rate-setting committee. Short-term rates tend to rise when the Fed engages in monetary tightening and fall when the central bank begins easing.

Longer-term interest rates, on the other hand, are more closely linked to investor sentiment around the economic outlook. Long-term rates will rise during periods where economic growth is projected to be strong and fall during times when a recession is anticipated. Though the yield curve is often upward sloping, these differing drivers can lead to situations like the one we’re experiencing now, where the yield curve is inverted—typically viewed as a warning sign of a looming recession.

Although short-term rates are the most closely linked to monetary policy, the shape of the yield curve can be affected by a range of factors, including the supply of bonds in the market, economic sentiment, and the pace of monetary policy compared with investors’ expectations. By looking at how the yield curve has shifted in prior time periods, we can see evidence of the market’s tendency to anticipate a pivot in central bank policy. 

Historically, the 10-year U.S. Treasury yield has peaked in advance of the Fed concluding a rate-hiking cycle, while the yield curve often begins to steepen before the Fed begins its transition to a more accommodative monetary policy stance.

Which fixed-income instruments tend to do well when the yield curve steepens?

Over much of the year, the yield curve has been steepening as markets have priced in expectations of a Fed pivot from its restrictive monetary policy.

This anticipated Fed pivot has led to increased demand for short-term bonds, pushing their yields down relative to intermediate-term yields. As a result, the yield curve is steepening, indicating a growing difference between short-term and long-term interest rates, often signaling improved economic growth expectations. In this context, being exposed to the “belly” of the yield curve, typically the intermediate-term bonds are preferable because they tend to balance yield and interest-rate risk.

The wings of the yield curve, representing the very short or very long maturities, can be more sensitive to changes in monetary policy and economic conditions. Therefore, focusing on the belly allows for the potential of enhanced returns while mitigating the risks associated with extreme movements at either wing of the curve.

As we continue to move through the next stage of the monetary policy cycle, we anticipate a further steepening of the yield curve driven by differing influences on short- and long-term yields. In this environment, strategies that can take advantage of yield curve positioning tactics, like allocating to the belly of the yield curve, could provide active managers with an additional lever to add value for investors.

Which fixed-income instruments tend to do well when the Fed is cutting rates?

Intermediate-term bonds have the opportunity to perform well when the Fed cuts interest rates because bond prices move inversely to yields. As rates fall, the existing bonds with higher yields become more attractive, causing their prices to rise.

This price appreciation adds to the bond’s total return on top of the regular income generated by the bond’s yield. Intermediate-term bonds, which typically have maturities of 5 to 10 years, are especially well positioned to benefit from rate cuts. They’re sensitive enough to capture price gains when rates drop, but they also carry less interest-rate risk than long-term bonds, making them an attractive balance of income and capital appreciation during periods of monetary easing.

Elevated yields have created an asymmetric return profile for intermediate-term bonds, with potential for both income and price appreciation. If the 10-year U.S. Treasury yield rises to 6% over the next 12 months, we could see high single-digit negative performance. Conversely, if the yield falls, the index could achieve high single-digit positive returns with even greater upside if yields return to prepandemic levels.

How should my fixed-income portfolio be positioned?

When assessing their fixed-income allocations, investors should be aware that it’s not quite as simple as knowing whether we’re in a rising or falling-rate environment, with the shifting yield curve also having a meaningful effect on bond performance. Given this added nuance, how to position a fixed-income allocation isn’t always a simple answer of holding short duration bonds once central banks begin to raise rates and then allocating to long duration bonds when monetary policy becomes more accommodative. Given the current easing cycle of the Fed, now is an excellent time to connect with your financial advisor to evaluate whether your bond portfolio is appropriately positioned, considering both your personal investment goals and the overall market outlook.