· Peak in rates an excellent opportunity to buy long-duration bonds

• Markets sniff out the end of the hiking cycle

Peak rates are bullish for bonds.

It’s a well-established fact that bonds with longer maturities are more affected by changes in interest rates compared to those with shorter maturities. This is because there is a negative relationship between interest rates and bond prices. When interest rates fall, the prices of longer-dated bonds tend to rise more significantly than those of short-dated bonds. This is due to the extended period over which the fixed interest payments are received, making them more valuable when rates are lower.

Hence, the start of a cutting cycle for rates (red arrows) boosts the performance of the TLT Bond ETF, which focuses on long-term U.S. Treasury bonds (20y +) experience a substantial increase in value, as shown by the green arrows.

Source: TradingView

The market sniffs out the end of the hiking cycle

Factoring in the latest data, the Market expects rates to be lowered no later than the middle of 2024.

CME FedWatch signals the likelihood of changes to US interest rates based on Fed monetary policy.

Currently, traders are pricing in virtually zero chance that the US central bank will raise rates in its next meeting.

The dollar index has also been falling for the fourth straight session to the lowest levels since August, indicating that FX traders view the Fed to be done with hiking rates.

Considering the possible benefits from reductions in interest rates, which have recently increased at the quickest pace in four decades, it’s important to note the significant impact these rate changes have had on the TLT. It experienced a dramatic decrease in value, almost 50%, due to these rapid rate hikes. However, when this trend starts to mean-reverse, and rates begin to fall, investing in the long end of the yield curve becomes an attractive strategy.

History often rhymes

Following the 2021 challenging year for U.S. Treasury bonds, 2022 proved even more difficult as the market experienced its worst performance since the French Revolution.

It’s hard to imagine the bond market recording negative returns for three consecutive years, as this has never occurred in recorded history.

Hence, will 2023 be the exception to the rule, or will it finally break the negative trend and allow bondholders to breathe a sigh of relief?

Source: BofA

The bond market is modestly negative year-to-date in 2023. However, renewed optimism for the end of the hiking and beginning of the cutting cycle sooner than expected has lifted it over 3.0% in November.

Latest data mixed

However, the lagged effects of rate hikes will need some time to get filtered in through the economy, driving softer growth, which could lead to triggering periods of volatility.

The market narrative is that inflation is softening as growth is holding up, which looks to be, to some degree, the case as undoubtedly inflation has come crashing from nearly double digits to the latest reading of 3.2% last week. Further, companies mentioning « recession » on earnings calls fell to 11%, far from the peaks of 42%-46% in 2020 and 2022, according to Factset.

However, demand is softening, as retail sales dipped in October for the first time in seven months, although less than expected, showing some signs of resilience.

Conclusion

Historically, bonds exhibit great risk/returns trade-off as the Fed pivots to lower rates in Q1 or Q2 of 2024. If inflation continues to decline in conjunction with softening economic data, we might see those cut even earlier.

Finally, we might expect some market volatility as the delayed effects of the recently elevated interest rates fully manifest in the economy.

Investors can buy long-duration bonds using our 5x 20+ Year Treasury Bond

Alternatively, they can short long-duration bonds using our -5x 20+ Year Treasury Bond