EDV: Have we seen the peak in long rates? Maybe not (NYSEARCA:EDV)

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Thesis

The Vanguard Extended Duration Treasury ETF (NYSEARC:VDE) is a fund that invests its cash in long-term Treasury STRIP securities. With a massive duration of 24.2 years, the fund’s performance is driven by the long term of the Treasury bill curve. There have been many speculations regarding the ultimate trajectory of long rates, with unclear answers. What has firmed up in recent months, however, is the predicted trajectory for Fed Funds, whose price peaks at 5.25% per Goldman:

golden man

Federal Funds (Goldman)

In this article, we will explore the historical relationship between 30-year rates and Fed Funds, and try to draw conclusions regarding the 30-year peak levels for this cycle. Although history does not repeat itself exactly, it often rhymes, so we believe we can use historical patterns to identify an appropriate range for long-term peak rates.

Historical relationship between Fed Funds and 30-year Treasury yields

Let’s go back to the historical relationship between Fed Funds and long rates:

fed him

Fed Funds vs 30-Year Rates (The Fed)

The chart above plots the Fed Funds rate in blue and the 30-year constant-maturity market yield for Treasury bills. Several interesting facts should be noted:

1) Fed funds can actually beat 30-year treasury yields.

  • while this seems counter-intuitive given the concept of term premiumhistory has shown us that Fed Funds can occasionally overtake long rates
  • looking back nearly 20 years, we can see this dislocation happening only twice, both at the end of monetary tightening cycles

2) The average duration of maturities with Fed Funds above long rates is 1 year, and the maximum spread observed is around 100 bps

  • when considering this historical relationship, it is important to quantify the period of time over which the dislocation occurred and the maximum spread observed
  • if fed funds exceeded long treasuries for only a few days, then occurrence wouldn’t really matter to derive a maximum long rate for that cycle
  • the correlation between the timing and the gap for the two occurrences is important to infer similarity to the current tightening cycle
spread

Fed Funds / 30-Year T-Bill Spread (Author)

  • the two historical occurrences are therefore quite well correlated, the maturities of the inverse term premium being around 1 year, with a maximum difference between 75 and 104 basis points

3) The 2006-2007 tightening cycle also peaked with Fed Funds at 5.25%

  • history often rhymes, and Goldman’s call for peak Fed Funds in this cycle matches the highest rate seen in the 2006-2007 tightening cycle
  • so the Fed would just go back to what it had done before in the not so distant past

If history is any guide, we should expect a similar development in this cycle. Working from the historical chart above and Goldman’s prediction would give us a 30-year terminal rate of 4.25% to 4.5% over this cycle. We have already seen long rates touch this level before falling back:

rates

Rates over 30 years (investing.com)

Long rates peaked at 4.38% before falling back below 4%. As we saw with our historical chart, the relationship does not peak until the Fed has finished raising rates. Expect long rates to return to the 4.25% to 4.5% “box” as economic data is not soft and the GS trajectory is priced in.

What does this mean for EDV?

Admittedly, the vehicle only has a duration of 24.2 years, but the price correlation with long rates is quite close since it overlaps the structure of the 20-year/30-year terms. We saw long peak rates in this cycle on October 24, and the associated price for EDV was around $75/share. Expect this to be reviewed but to act as a soft bottom for the fund. The price of EDV is entirely determined by long rates and, as we have seen in the analysis above, we expect them to peak between 4.25% and 4.5%.”

The fund is down -38% since the beginning of the year given the violent increase in rates and the long duration, and it is approaching a level “generational buy”. Do we believe the Fed will go much higher than GS predicts? No.

As interest rates on US Treasury securities rise, so will the federal government’s borrowing costs. The United States was able to borrow cheaply to respond to the pandemic because interest rates were historically low. However, as the Federal Reserve raises the federal funds rate, short-term rates on Treasury securities will also rise, making some federal borrowing more expensive. At the end of May, the Congressional Budget Office predicted that annual net interest expense would total $399 billion in 2022 and nearly tripled over the next decade, from $442 billion to $1.2 trillion:

Cost

Net interest cost (OBC)

The sudden rise in net interest charges is not sustainable in the long term and rates will have to come down. This is another reason the Fed is moving so quickly – it needs to raise and then lower rates as soon as possible to minimize both inflation and net interest costs.

Conclusion

EDV is a long-term treasury fund. With a duration of 24.2 years, the fund’s performance is entirely driven by the long end of the yield curve. Despite the concept of term bonus, history has shown us that Fed Funds can be higher than long rates. Over the past twenty years, we have witnessed two historic instances where the Fed Funds exceeded 30-year rates, both of which occurred during past monetary tightening cycles. The average duration of the reversal was 1 year, with the spread peaking at 100 bps. One of the two events is the 2006-2007 tightening cycle when fed funds peaked at 5.25%. With Goldman now anticipating the Fed hitting an all-time high of 5.25% in fed funds next year, past historical correlations would indicate that 30-year rates would peak in the 4.25% to 4.5 “box.” %. This yield range implies a “soft bottom” in the price of EDV at around $75/share.

Carol N. Valencia