The Fed has paused its interest rate hike in its past two meetings. They believe they may have reached the tail-end of their rate hike cycle. The market shares this view and expects the interest rate to reverse next year. If you agree with the market and the Fed, how can you position yourself to benefit from this projection?
Where Are Interest Rates Heading?
Inflation
The Fed hiked interest rates mainly because inflation was red hot in 2022. Where are we with inflation today?
The chart shows that inflation has been on a steady decline this year. The latest CPI October 2023 reading was 3.2%. Core CPI was 4.0%. These numbers have dropped significantly from 9.1% for CPI and 6.6% for Core CPI in 2022. If inflation is already declining and getting closer to its target rate of 2%, the Fed has little reason to keep raising rates. Indeed, they have held the rates steady in their last two meetings.
Market Expectation
The market also agrees with the Fed’s sentiment and expects that we may have reached the tail-end of this rate hike cycle.
The market expectation is even more aggressive. The market expects rates to peak at the current level and to start reversing in the 2nd quarter of 2024. The end-of-year rate is expected to be around 125bps lower than the current rate. Do you agree with the market?
Recession Incoming?
Before we get too excited about the possible interest rate reversal, there is a catch: historically, interest rate cuts are usually accompanied by a recession.
The Fed mentioned that they do not forecast a recession. Instead, they expect a soft landing scenario, where inflation moderates while the economy grows. In our opinion, this is the best-case scenario. But is this a realistic expectation?
When interest rates are high, it is harder for businesses to borrow to fund their growth. We call this a restrictive economic condition. Should this restrictive environment persist for longer, there is a good chance that the overall economy will not be able to grow and start contracting. This is the recession.
The most historically accurate indicator of an incoming recession is an inverted yield curve. And guess what? Our yield curve is currently inverted.
The blue line above shows the yield of the 10-year minus the yield of the 2-year treasuries, while the red line shows the 10-year against the 3-month treasuries. A negative value means the yield curve is inverted, meaning the short-term maturity yields higher than the long-term maturity. The grey-shaded areas indicate a recessionary period.
You can see that every time an inverted yield curve occurred, a recession followed several months later. Our current yield curve is inverted, but we have yet to get a recession. Will history rhyme again this time?
We have been in a restrictive environment for a while, and many expect recession to come soon. If this downturn arrives, the Fed will likely cut the interest rate fast, and a new bull market may form afterward. The issue, however, is that there can be a period when the market is not doing well. The stock market may even enter a bear market if we get into a deep recession. REITs, which are supposed to benefit from lower rates, may also face a declining rental income if the economy enters a prolonged recession.
Is there a way to insulate us from the possible recession while benefiting from the incoming rate cuts?
Benefiting From Bond Price Appreciation
Let us introduce you to the government bond. Yes, your regular government bonds, such as US treasuries. Before we get started, you need to understand the correlation between interest rates, bond yield, and bond price. Bond yield and price have an inverse correlation, meaning when yield rises, price declines, and vice versa. When interest rates rise, bond yield also increases, which means bond price declines.
Well, interest rates have risen significantly, so the bond price has also declined. Let’s look at the price movement of the US treasuries:
In this chart, we are looking at the price movement of TLT, an ETF tracking the price of long-term US government bonds (>=20 years). We can see that TLT corrected significantly around early 2022 when the Fed started hiking interest rates. It fell from >$140 to reach a low of $84. It has since rebounded slightly after the optimism that the Fed may have reached its peak rate hike cycle.
If you think the interest rate will decrease soon, you may consider getting into this TLT trade. When the bond yield falls, the bond price will increase, which will also cause the TLT to rise.
By entering into the TLT trade, we can also protect ourselves from a possible recession because the Fed will very likely start cutting interest rates should a recession occur. Unlike the stock market, which may drop during a recession, TLT should continue to rise as the Fed continues its rate cuts. This way, we can protect ourselves against the downside of a possible recession while still benefiting from the interest rate cuts.
If you want to invest in or trade US equities, you need to use an investment broker with access to the US market. You can follow our summary of some of the best online brokerage accounts in Singapore.
Disclaimer: Trading is a high-risk activity that may incur capital loss. Before getting into any trade, you should always fully understand what you are doing. The information At the time of this writing, the author holds a small position in TLT.
