The prediction of higher interest rates has been ongoing since the government went all-in on a variety of so-called “inflationary” efforts. Inflation hasn’t happened and rates are still low across the yield curve. So-called “bond vigilantes,” having been wrong for 7 years now and are still calling for inflation and subsequent higher interest rates. Will higher interests happen? I don’t know. Regardless, the point of this piece is not to pontificate on where interest rates will go, but to look back in time and assess what happens when interest rates have risen dramatically.
Before addressing this question, let’s take a look at historical yields.
Visualizing 110 Years Of Treasury Yields:
The figure below shows the U.S. 10-year treasury bond rate from 1900 to 2015. We can see that, historically, the Fed has hiked rates to control high inflation, and has lowered rates to stimulate the economy. During the early 1980s recession, inflation rose to double-digit highs, and Paul Volker and Fed took the proverbial “punch bowl” away, raising rates to over 15%. It was at this point, in 1981, that the 35-year bull market for bonds began.
From 9/1981 (interest rate peak) to 9/2015, the compounded annualized growth return (CAGR) for US 10-year treasury bond was 9.15%, with an attractive Sharpe ratio of 0.6. Over the same period, the CAGR for SP500 was 11.43%, with a Sharpe ratio of 0.52. The worst drawdown for the US 10-yr bond was only -10.51% while for the SP500 it was a staggering -50.21%.
Today, rates are at historically low levels, but investors think this can’t last very long (even though the market has predicted rate hikes for the past five years.)
Finally, here is a chart of bond performance and inflation. As expected, there is a negative relationship between bond performance and inflation.
With some baseline stats out of the way now we can ask the question: What happens to bonds when interest rates spike?