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 inverts?

The yield curve has been inverted since mid-2022, meaning that U.S. Treasuries with longer maturities are now offering lower yields than short-dated bonds. Historically, a yield curve inversion has been a reliable predictor of a looming recession, suggesting that investors might want to increase the quality of their bond allocations to prepare for an economic downturn.

Looking at historical performance supports a shift to higher-quality bonds after the yield curve inverts. When a recession has followed a yield curve inversion in the past, core bond allocations, including mortgage-backed securities and investment-grade corporates, have historically outperformed other bond market segments. Shorter duration bonds have also done well in this scenario, outperforming more credit-sensitive areas of the bond market.

Which fixed-income instruments tend to do well during a Fed pause?

Central banks are tasked with the responsibility of moderating fluctuations in the business cycle, a function most visibly expressed through interest-rate decisions. That said, there can be periods where central banks keep interest rates unchanged, holding steady while continuing to monitor the development of the economy and inflation. This is a scenario that could soon materialize, with a softening economy and cooling inflation soon leading the Fed to take a wait-and-see approach. While past performance is no guarantee of future results, history shows that such a backdrop has often coincided with a period of strong performance for intermediate duration bonds, particularly when compared with its short-term peers.

This outperformance is due to the decrease in longer-term yields that tends to happen during a Fed pause, as the lagged effects of monetary policy flow through the economy and investors anticipate a period of subdued economic growth or a possible recession. 

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, then allocating to long duration bonds when monetary policy becomes more accommodative. As we potentially near the end of the Fed’s tightening cycle, now is a great time to connect with your financial professional and assess whether your bond portfolio is positioned appropriately, keeping your individual investment goals and the market outlook in mind.