Bonds Tumble as Fed Focuses on Inflation
During this quarter, core fixed income returns had their worst month in more than 40 years amid their worst year in recent memory.
- The Ice BofA US Master Index was down 4.5% in September and is down 14.8% year-to-date
- Investment grade corporate bond spreads widened back to June levels
- Investment grade corporate bonds underperformed Treasuries by about 3.6% this year
- Mortgage-backed securities have been surprisingly weak and underperformed Treasuries by 3.1% this year
Did Bond Yields Peak?
We have been on watch for wild cards amid an extreme rise in both nominal and real interest rates globally. Due to the use of leverage, large moves in major asset classes often has known-on effects. This materialized in the United Kingdom this quarter where government bond yields surged amid loose fiscal policy initiatives. This ended up putting some pension funds in peril as their safe assets were down more than 50%, and this doesn’t factor in often used leverage. The Bank of England relented and began unlimited purchases of longer dated government bonds.
The other key event of the third quarter was the relentless campaign from Fed officials to wring out any hope of an early 2023 cut in the federal funds rate. The Fed is now committed to holding rates high amid weakening growth momentum. In every cycle the federal funds rate has moved above the year-over-year change in the Consumer Price Index (CPI). It appears the Fed is looking to get the federal funds rate to around 4.5% and wait for CPI to fall below.
The confluence of these two events pushed two-year Treasuries up 132 basis points in the quarter. The 10-year yields jumped 81 basis points and pierced 4.0% but failed to close above. Our outlook for duration improved as the quarter ended. Duration was increased in strategy accounts toward a slightly overweight positioning. The probabilities are signaling that the cyclical downswing in bond yields may have begun.
- Momentum weakened with each move lower in yields this cycle, which coincides with an extreme downside move
- The Bank of England made a major policy pivot, which was followed by the Reserve Bank of Australia only raising rates 25 basis points instead of 50, thereby sparking a large global bond and equity rally
- Economic momentum continues to weaken
Secular Forces Favor Higher Yields in the Long Term
While the cyclical outlook for bonds may be improving, the secular forces for rising yields may have strengthened in the quarter. The U.S. passed several significant spending bills despite already elevated inflation. Student loan forgiveness was pushed through. The energy crisis in Europe was met with stimulus measures. Prominent countries around the globe continue to promote populist policies and fiscal deficits amid record inflation. There is a shortfall of commodities from oil to lithium to copper that threaten to make higher highs with subsequent economic recoveries. Amid this backdrop, there is growing consensus that if the Fed just stamps out inflation now, we won’t have to worry about it in years to come. The lessons from the 1970s would suggest otherwise as the Fed is forced to fight inflationary fiscal policies.
In summary, it is increasingly likely that yields may have peaked this cycle and will head lower until the end of the down cycle. However, they may make a higher low due to secular forces. This is also not the best environment for corporate bonds and the strategies are positioned below their historical averages to manage risk. The environment for corporate bonds will improve once the Fed has clearly begun an easing cycle.
Source: BTC Capital Management, Ibbotson Associates, FactSet, Refinitiv.
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