Investors should consider pivoting to longer-dated bonds instead of lingering in cash and money-market funds, advises Saira Malik, the CIO at Nuveen. Her recommendation is based on historical data showing that the expansive $55 trillion U.S. bond market typically outshines short-term Treasurys towards the end of the Federal Reserve’s rate hiking cycles, a pattern that has been consistent since the 1990s. The bond market has demonstrated an average 5.5% three-month rolling return following the last rate hike during the past four Fed hiking cycles, while short-term Treasurys returned a modest 2.1%.

However, it’s worth noting that the bond market’s superior performance tends to dwindle by 12 months when compared to short-term positions, as evidenced by the Bloomberg U.S. Aggregate Bond Index’s performance relative to the Bloomberg U.S. Treasury 1-3 Year Index. Malik, in a recent client note, underscored that the broader market usually experiences a robust relief rally immediately after the Fed pause and mostly outperforms the following year. This trend supports the view that overallocating to cash or short-term government debt may be a misstep, suggesting that investors might benefit from addressing their duration underweights.

Shifting to Longer-Dated Bonds: A Profitable Investment Strategy?

Investors with substantial holdings in cash and money-market funds may want to consider transitioning into longer-dated bonds, advises Saira Malik, the Chief Investment Officer at Nuveen. Drawing from historical data, Malik suggests that the broader $55 trillion U.S. bond market frequently outperforms short-term Treasurys towards the end of Federal Reserve rate hiking cycles.

A Historical Perspective on Bond Market Performance

By examining previous Federal Reserve rate hiking cycles since the 1990s, it becomes evident that the bond market generally yields higher returns than short-term Treasurys. For instance, the bond market has historically produced an average 5.5% three-month rolling return following the last rate hike during the past four Fed hiking cycles. In comparison, short-term Treasurys returned only 2.1%.

However, the outperformance of the bond market typically diminishes by 12 months when compared to short-term positions. Despite this, the bond market usually experiences a strong relief rally immediately after the Fed pause and continues to outperform in the following year.

The Potential Mistake of Overallocating to Cash

Malik believes that overallocating to cash or short-term government debt could potentially be a misstep for investors. She suggests that investors should consider reducing their duration underweights. Individuals can gain exposure to Wall Street’s bond indexes through related exchange-traded funds, such as the iShares Core U.S. Aggregate Bond ETF and the SPDR Bloomberg 1-3 Year U.S. Treasury Bond UCITS ETF for short-term Treasury exposure.

The Fed’s Stance and the Inflation Outlook

In a recent address at the annual Jackson Hole gathering in Wyoming, Fed Chairman Jerome Powell indicated that further rate hikes might be necessary to maintain a declining U.S. cost of living. This comes despite current rates being at a 22-year high and a significant drop in inflation over the past year. Malik views the slowing housing inflation, marked by a pullback from home buyers as the benchmark 30-year mortgage rate hit an average of 7.31% (the highest since 2000), as a positive development on the inflation front.

A Look Ahead: Economic Growth and Treasury Yields

Looking ahead, Malik expects U.S. economic growth to slow down and foresees a "partial retracing" of the 10-year Treasury yield following its recent surge. She predicts that the yield peak will occur within the last few months of the final rate hike in the current tightening cycle. This peak is expected to happen at either the September or November Fed meeting, followed by a decline in the 10-year yield through the year-end.

Takeaways

In conclusion, while cash and short-term government debt have their place in a well-diversified portfolio, investors may want to consider the potential benefits of shifting towards longer-dated bonds. Historical data shows that the broader U.S. bond market often outperforms short-term Treasurys at the end of Federal Reserve rate hiking cycles. However, like all investment strategies, this approach is not without risks and should only be adopted after careful consideration of one’s individual financial circumstances and risk tolerance.