Fed tightening cycles - bond evidence is clear

The Fed tightening cycle is almost upon us even if no action is taken this month and investors are still trying to sort out what will happen to financial markets. There have been 12 tightening cycles since 1955, so the overall sample size is small. It is even smaller if we focus on the post 1980 period. In the last 35 years, there have been six tightening cycles.

During those six periods, short rates rose on average 275 bps and the tightening cycle lasted about 59 weeks. Both 10-year and 2-year yields increased in all cases. The graph shows 10-year Treasury yields in blue and 2-year yields in red. The evidence for what should happen is very clear. The market does not like tightening surprises regardless of being warned. The 1994-95 tightening was brutal on bond markets in the spring of 1994. The 1999-00 tightening offset the liquidity injected into global markets after the Asian crisis. The stock market nosedived in 2000 and cut short the tightening cycle. The 2004-06 cycle was a slow march higher than was not able to stop the housing excesses prior to the Financial Crisis.  

For the 12 tightening cycles since 1955, the average length has been just under two years. The median increase in short rates has been 300 bps but this includes periods of much higher nominal rates. In nine of 12 cases, the stock market moved higher in the year after the first increase. Bond yields have gone up 11 of 12 cases in the year after the first tightening. 

For the current tightening, Fed's intentions have been clear; nonetheless, the Fed forecasts have been biased to rate increases sooner and more dramatic.  These Fed forecasts have been wrong. The dot plots from the Fed actually forecasts that the rate increase may be greater than the average increase from our sample of six, albeit the forecasts suggest that the increase will be over a longer period. Holding bonds will not be a safe strategy although bond behavior in a zero interest rate environment may be more muddled.