Anatomy of a Selloff

While an expansionary fiscal policy played a major role in supporting risk assets in the first half of 2023, the second half of this year has been marked by uncertainty around fiscal sustainability and the implications for long-bond issuance. The most recent episode of volatility began after the US Treasury’s quarterly refunding announcement on July 31. After the announcement and through the FOMC September policy decision, financial conditions tightened sharply, which has resulted in a market-wide selloff across equities and bonds, echoing the experience of 2022.

Financial Conditions Tighten

Financial conditions are a collection of asset prices and interest rates that have the potential to affect the real economy. Monetary policymakers typically view financial conditions as a measure of the transmission of monetary policy on the real economy. While economists have varying methods of constructing a financial conditions index, the components are commonly comprised of money market rates, bond yields, credit, and asset prices (typically equities).

The table below shows the change in financial conditions since July 31, when concerns around fiscal sustainability came to the forefront after the Treasury’s quarterly refunding announcement. The figures are normalized and include z-scores – how many standard deviations does the move signify when compared to market history?

Except for money markets, financial conditions have tightened across the board. The anomalous moves have largely been in long-term interest rates, which are outsized by multiple standard deviations relative to their historical volatility. The moves in equities and credit have mostly been within normal ranges, but should financial conditions continue to deteriorate, we believe it could spread to these components as well. To the extent that conditions ease, yields have the scope to move much lower than current levels.

Starting Yield and Forward Returns

Given that bond yields have risen sharply in recent months, what does this mean for future returns for long-term bond investors? In the table below, we bucketed the forward one-year return across different yield ranges going back to 1976.

We listed the average one-year return for a given starting yield range, the average performance in up/down periods, as well as the hit rate.

As expected, the higher the yield range, the better the average one-year return given the elevated starting level of yield. The hit rate also improves, with the best chance of positive periods being in the yield range of 600 bps to 800 bps. As of October 5, the yield-to-worst for the Aggregate Bond Index was 5.5%. Historically, in that yield “zone,” the average return over the following year would be 5.1%, with 91.6% of the occurrences being positive.

We maintain that given the level of starting yields, the risk/reward for fixed income over a longer-term time frame remains attractive. While the economy is still in an expansion phase, higher rates beget a higher cost of capital, which will weigh on economic growth and consumption, starting the rate cycle anew.

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