1) A 10-year bond purchased today should return about 2% more per year over the next decade than a bond purchased at the start of 2021
How do we know? Because the current yield on bonds is extremely efficient at foretelling the return on high grade bonds. The chart below tells this story. For every month dating back to 1976, we measure the current yield on the 10-year Treasury note at the start of the month and the return over the subsequent 10-years for the Bloomberg Aggregate Bond Index. The plots below represents those 437 monthly data points1.
You can see the distinct and clear linear relationship from the data. The higher the starting yield, the higher the return over the next 10-years. Of course, we don’t know the path that bond returns will take over those 10-years. But, we can say with a high degree of confidence that bond returns over the next 10-years should be significantly higher than bonds purchased 18 months ago just for the fact that 10-year Treasury yields are roughly 2.2% higher than today than they were 18 months ago.
2) Recent changes in interest rates really do not offer any predictive utility about future changes in interest rates
The concept that interest rates will keep going up because they have been going up is based entirely on emotion or heresay rather than on empirical evidence or objective data. There is just no evidence that supports this theory. Consider the data below where we compare the change in 10-Year Treasury yields over the past 3 months (horizontal axis) to the change in 10-Year Treasury yields over the next year (vertical axis). Again, the plots represents each beginning-of-month data point since January 1976.
Try your best but you will not find any relationship between the two. The amount of variability in future interest rate changes over the next year predicted by changes over the past three months is a whopping 0.1% which is to say that there is no connection between recent changes in interest rates and future changes.
3) Federal Reserve rate hikes tend not to harm long-term bonds
The futures market suggests that the Fed is likely to increase the Federal Funds Rate by another 1.75% – 2.25% in 2022 beyond the 50 basis point hike last week. Many take this to mean that interest rates are headed higher. What is not well understood is that the Federal Reserve does not set or directly control intermediate and long-term interest rates that matter most to bond prices. The Fed uses open market operations to target a level for the rate that commercial banks charge between themselves on overnight loans. This extremely short-term rate has a strong impact on the yield of money markets, bank savings accounts, and floating rate loans but less an impact on longer-term rates which are a function of market expectations.
In all of the Fed rate hiking cycles this century, bond returns (Bloomberg Aggregate Bond Index) have been positive in the 1-year period following the onset of rate hikes. Going further back – to the start of 1976 – bond returns have been positive in 85% of one year periods when the Federal Reserve was hiking interest rates2.
The chart below depicts this relationship with each plot representing the trailing 12-month change in the Fed Funds rate (horizontal axis) versus the 12-month return for the bond market over the same time period (vertical axis). Although there is a small relationship between the two, the more important takeaway should be that bond returns tend to be positive over most time periods, regardless of Fed policy.