With Interest Rates So High, Is Cash Still King?
By Tome Martinez, Economist, Global Financial Data
Last year could safely be called the worst year ever for bond investors, a fact that GFD discussed in the article, “The Lost Decade”. The velocity of interest rates impacted those companies that benefited the most from the prior low-rate environment. It also impacted those investors and institutions that believed in the long-term, low-risk characteristics that government bonds from developed nations generally exhibit. It was clear in the Spring of 2022 that global inflation was an issue to central banks. On May 3, 2023, the Fed raised interest rates for the tenth time beginning in March of 2022. This has turned out to be the largest year-over-year acceleration in the federal funds rate on record with a 4200% increase in the monetary rate.
Figure 1: United States Federal Funds Rate, Year-over-Year Change (December 1940 – March 2023)
The US 2-Year Bond Yield
The performance of the United States (US) two-year bond gives an indication of the Fed’s impact on the fixed income space. During the monetary policy initiated during the initial stages of the Covid Pandemic, the yield on the US two-year note, illustrated in Figure 2, dropped to as low as 0.09% in February of 2021. At the start of the most recent Federal Reserve rate hiking cycle the corresponding yield was marked at 1.94%. Nearly one year later, we observed a recent closing high at 5.05% (March 8, 2023). After reaching this most recent high, financial markets have deteriorated as bank failures at three large banks have brought into question the stability of the bank system. Government bonds are again acting as a safe asset class with interest rates responding to the uncertainty by falling dramatically to 3.89% as of May 3, 2021, that also happens to mark the anniversary of the most recent fed rate hiking cycle. The quick fall in rates over this same period has not been seen since the stock market crash of 1987.
Figure 2: United States 2-Year Government Bond Yield (January 2021 – March 2023)
Historical Actions in Times of Financial System Stress
Historically, there are moments where some of America’s most notable investors used a period of financial market stress to make sizable investments in distressed companies. During the Bank Panic of 1907, a small group led by J.P. Morgan took advantage of liquidity issues with some banks and trusts as well as over-indebted companies to purchase them at discounted prices relative to what they were before the panic. Other companies were not given that financial lifeline and were forced to close. Ultimately, they were able to eliminate competition and/or grow their existing businesses.
During the Global Financial Crisis (GFC) starting in 2008, Warren Buffett made large investments in Goldman Sachs and General Electric while selecting not to invest in Lehman Brothers and American International Group. He later made a large investment in Bank of America. In all instances, the selected companies were distressed from low cash positions that allowed Buffett to invest at a discount to the existing valuations.
With the current uncertainty in the financial markets, it would be logical to take your money out of the stock market, and to put these funds into short-term treasuries or money market accounts. However, even if you do not have the financial resources of J.P Morgan or Warren Buffett to negotiate discounted prices for distressed assets, does the urge to remove investment risk ultimately lead to the better returns over the short and intermediate term?
Prior History of 2-Year Yields at Five Percent
To examine this question let’s look at the returns of the traditional S&P 500 compared to the three-month US Treasury Bill over three, six & twelve months. To narrow the sample, we looked for instances where the US Two-Year Bond yield initially broke through the five percent level. A new sample will be taken at least twelve months after the initial breakout and once the yield closes below five percent for at least one month. A sample of eleven periods were found based on these two parameters (excluding the most recent instance that occurred on March 8, 2023). From Figure 3, you can see that this initial five percent breakout did not necessarily signal the top of yield hiking cycle. The two-year yield is one measure of the market’s perspective of economic conditions. In more than half of these instances, the Federal Funds Rate was higher in twelve months than the time of the initial break above five percent on the two-year yield.
|
US 2 Year Bond Yield
|
|
Date
|
5% break
|
3 mo. out
|
6 mo. out
|
12 mo. out
|
|
12/31/1959
|
5.18
|
3.95
|
3.64
|
2.77
|
|
2/28/1966
|
5.02
|
5.13
|
5.92
|
4.67
|
|
8/30/1967
|
5.21
|
5.59
|
5.42
|
5.23
|
|
4/30/1971
|
5.28
|
6.59
|
5.03
|
5.16
|
|
6/30/1972
|
5.48
|
5.93
|
5.96
|
7.16
|
|
1/15/1992
|
5.07
|
5.22
|
4.25
|
4.31
|
|
3/18/1994
|
5.03
|
5.88
|
6.42
|
6.69
|
|
2/20/1996
|
5.18
|
6.02
|
5.97
|
5.85
|
|
2/23/1999
|
5
|
5.3
|
5.66
|
6.61
|
|
5/10/2006
|
5.01
|
4.93
|
4.73
|
4.7
|
|
6/7/2007
|
5.03
|
3.9
|
3.12
|
2.4
|
|
AVG
|
5.14
|
5.31
|
5.10
|
5.05
|
Figure 3: US 2-Year Government Bond Yield, Five Percent Breakout Sample with Closing Yields at Three, Six and Twelve Months Out in Time
Performance of the 3-Month Treasury and S&P 500 Index During the Selected Periods
Global Financial Data’s (GFD) total return indexes were used to measure the over time. The Three-Month Total Return Index is a historical series using the minimum coupon rate from government or corporate bill followed later by the yield on the three-month treasury bill. The S&P 500 Total Return Index is a historical series based on the performance of the members that make up the underlying index at that time. Both indexes assume reinvestment of interest or dividends where applicable.
As Figure 4 shows, over the first three months of the sample period, the return US Three-Month Total Return T-Bill Index ranged from 0.97% to 1.23% with an average return of 1.11%. Over twelve months, the return on the same index ranged from 2.93% to 5.49% with an average return of 4.5%. During the same three-month period, the return of the S&P 500 Total Return Index ranged from -7.33% to 5.7% with an average return rate of -0.99%. After twelve months, the return ranged from -1.55% to 28.07% with an average return rate of 6.78%.
|
|
US 3 Mo. T-bill Total Return
|
S&P 500 Total Return
|
|
Date
|
3 mo. out
|
6 mo. out
|
12 mo. out
|
3 mo. out
|
6 mo. out
|
12 mo. out
|
|
12/31/1959
|
0.97%
|
1.72%
|
2.93%
|
-6.79%
|
-3.29%
|
0.48%
|
|
2/28/1966
|
1.17%
|
2.39%
|
4.98%
|
-4.83%
|
-14.06%
|
-1.55%
|
|
8/30/1967
|
1.16%
|
2.42%
|
5.22%
|
1.16%
|
-3.07%
|
8.90%
|
|
4/30/1971
|
1.21%
|
2.41%
|
4.32%
|
-7.33%
|
-7.91%
|
6.80%
|
|
6/30/1972
|
1.07%
|
2.30%
|
5.49%
|
3.91%
|
11.72%
|
0.12%
|
|
1/15/1992
|
0.98%
|
1.88%
|
3.47%
|
-0.35%
|
0.62%
|
7.05%
|
|
3/18/1994
|
0.99%
|
2.11%
|
4.90%
|
-1.96%
|
1.45%
|
8.25%
|
|
2/20/1996
|
1.23%
|
2.54%
|
5.16%
|
5.70%
|
5.10%
|
28.07%
|
|
2/23/1999
|
1.08%
|
2.26%
|
4.91%
|
4.99%
|
7.70%
|
8.39%
|
|
5/10/2006
|
1.23%
|
2.49%
|
5.02%
|
-3.40%
|
5.38%
|
14.89%
|
|
6/7/2007
|
1.15%
|
2.06%
|
3.09%
|
-2.04%
|
1.91%
|
-6.88%
|
|
AVG
|
1.11%
|
2.24%
|
4.50%
|
-0.99%
|
0.50%
|
6.78%
|
Figure 4: Periodic Returns in the US 3-Month and the S&P 500 Total Return Indexes
From this sample, we can see that the results are mixed as to which investment path will offer a greater return in the short and intermediate term. In the short-term, an equity index investment would underperform the risk-free rate. Looking twelve months out, the average risk-free return of 4.5% whereas a broad-range equity investment in companies representing the S&P 500 could result in a negative annual return or a return that is a multitude better than the average risk-free return. Further, on average, the equity investment outperforms the short-term treasuries over that same twelve-month period.
The wide range in the twelve-month performance in the S&P 500 among this sample could be the result of the riskier nature of equities. However, that performance could be the result of other variables such as the Federal Funds Rate (FFR). This rate, in and of itself, is the Federal Open Market Committee’s (FOMC) own projection of the economy. Figure 5 shows the changes in the FFR over the selected time frames. Based on these observations, the FFR does not automatically peak when there is an initial break of the US two-year bond yield above five percent.
|
Fed Funds Rate from initial US2Y 5% break over 1 year
|
|
Date
|
Fed Funds Rate
|
3 mo. out
|
6 mo. out
|
12 mo. out
|
3 mo. % change
|
6 mo. % change
|
12 mo. % change
|
|
12/31/1959
|
4
|
4
|
3.5
|
3
|
0.00%
|
-12.50%
|
-25.00%
|
|
2/28/1966
|
4.63
|
4.75
|
5.5
|
4.75
|
2.59%
|
18.79%
|
2.59%
|
|
8/30/1967
|
3
|
4.5
|
4.75
|
5.75
|
50.00%
|
58.33%
|
91.67%
|
|
4/30/1971
|
4.25
|
5.5
|
5.13
|
4.31
|
29.41%
|
20.71%
|
1.41%
|
|
6/30/1972
|
4.5
|
4.88
|
5.5
|
8.88
|
8.44%
|
22.22%
|
97.33%
|
|
1/15/1992
|
4
|
3.75
|
3.25
|
3
|
-6.25%
|
-18.75%
|
-25.00%
|
|
3/18/1994
|
3.25
|
4.25
|
4.75
|
6
|
30.77%
|
46.15%
|
84.62%
|
|
2/20/1996
|
5.25
|
5.25
|
5.25
|
5.25
|
0.00%
|
0.00%
|
0.00%
|
|
2/23/1999
|
4.75
|
4.75
|
5
|
5.75
|
0.00%
|
5.26%
|
21.05%
|
|
5/10/2006
|
5
|
5.25
|
5.25
|
5.25
|
5.00%
|
5.00%
|
5.00%
|
|
6/7/2007
|
5.25
|
5.25
|
4.5
|
2
|
0.00%
|
-14.29%
|
-61.90%
|
|
AVG
|
4.35
|
4.74
|
4.76
|
4.90
|
10.91%
|
11.90%
|
17.43%
|
Figure 5: Changes in the Federal Funds Rate Over Three, Six and Twelve Months Out in Time
By incorporating the movement of the FFR into the average return over the selected periods, the return on both the risk-free treasuries and broad-based equities we can see that the average rate of return for the three-month treasuries increased or decreased based on the level of the FFR. This would be consistent with the concept that treasury yields are positively correlated with changes in the FFR, particularly the short end of the yield curve. Inversely, equity prices would tend to move higher as the FFR moves lower due to the FFR’s corresponding effect on bond yields.
| |
US 3 Mo. T-bill Total Return
|
S&P 500 Total Return
|
|
Average Return
|
3 mo. out
|
6 mo. out
|
12 mo. out
|
3 mo. out
|
6 mo. out
|
12 mo. out
|
|
Higher FFR
|
1.14%
|
2.34%
|
4.98%
|
-2.07%
|
0.17%
|
6.54%
|
|
Neutral or Lower FFR
|
1.08%
|
2.05%
|
3.66%
|
0.30%
|
1.08%
|
7.18%
|
Figure 6: Periodic Returns in the US 3-Month and the S&P 500 Total Return Indexes Based on Changes in the Federal Funds Rate
What is interesting about Figure 6 is that even when controlling for upward and downward movement in the FFR, the S&P 500 Total Return Index, on average, outperformed the Three-Month Treasury Index over twelve months. One might argue that it may be better to invest in short-term treasuries in the first few months following the initial break above five percent. This may allow an investor to gauge what the FOMC would do with the FFR and then investment weightings could adjust accordingly.
It is important to recognize that performance is not based on yield signals alone. While prices often reflect a consensus of known variables that are weighted for their importance, there simply is not a definitive set of factors that can be fully seen and accurately predicted into the future. In the economic climate coming out the initial response to the Covid Pandemic, many were drawing parallels to the 1970s era of high inflation while diminishing or outright ignoring the demographic, manufacturing and energy production differences that currently exist in the United States. Some analysts were calling for crude oil to reach $200 per barrel because of geopolitical events and the “reopening” of global trade. A little over a year later, and the result was the opposite of what those bull-call oil analysts predicted.
Conclusion
The current economic climate following recent bank failures has many immediately referencing the Global Financial Crisis (GFC) while diminishing or not considering the differences between insolvent and illiquid. Both are instances of bad risk management. However, it is easier and arguably the purpose of the Federal Reserve to take measures to help an illiquid bank with known higher quality assets than an insolvent bank that may never have the assets to cover the liabilities from short-term creditors (e. g., depositors). It was the Bank Panic in 1907 that largely brought about the creation of the Federal Reserve for times when human behavior out-ran the ability of otherwise solvent banks to remain liquid. It is unknown whether the current financial market stress will spread further than some domestic regional banks and a major foreign bank that arguably should have been dealt with during the GFC.
