Fixed Income Posts Worst Year in Over a Century
Core fixed income returns had their worst annual return in more than 100 years. The year began with the Federal Funds Rate at 0.25% and 10-year Treasury yield at 1.5% and ended with the Federal Funds Rate at 4.50% and the 10-year Treasury yield at 3.87%.
• The Ice BofA US Master Index was down 13.3% in 2022.
• Corporate Bonds underperformed, but only by about 2.0%.
• It was the first back-to-back calendar declines U.S. Treasury bonds had seen since 1959.
Forecasting the Upcoming Year
It was a difficult year for the credibility of the Federal Reserve. They predicted the Federal Funds Rate would end 2022 at 1.0%, but instead spent the year scrambling to catch up to elevated inflation readings. Despite this, there remains a heavy focus on the forecasts the Fed puts out. They are forecasting the Federal Funds Rate to end 2023 at 5.25%.
To be fair, the market was way off on its expectations for 2022 as well. The market is currently pricing in lower yields compared to the Federal Open Market Committee (FOMC). The market is only about 25 basis points behind on their terminal rate, but this is expected to be achieved in the first half of the year. The year-end expectation for the market is almost 75 basis points lower than what the Fed is forecasting.
No Standard Cycle
In early October, we mentioned that bond yields may very well have peaked. This is now becoming a consensus view across all areas of the investment landscape. What is clear is that inflation has peaked this cycle and global growth continues to decelerate. On top of this, the FOMC is truly committed to pushing inflation lower. Over the last 40 years this scenario has led to a near certainty that interest rates would fall until signs of a new cyclical upswing emerged. Therefore, it has become more likely that we’ll see recommendations to buy bonds from the general media.
The problem that may surface in 2023 is that low interest rates for the better part of the last 10 years caused investors to seek leverage in their fixed income allocations to achieve targeted returns. Money devoted to risk parity strategies have grown in the last decade as yields were suppressed after the Global Financial Crisis. The exact amount is unknown and reported amounts vary. However, we did find out in 2022 that participant behavior has changed. UK pension plans, which should normally be a natural buyer of government bonds when yields rise, were instead forced to sell. UK 30-year government bond prices fell 30% in four days on forced liquidation of embedded leverage. Yields only stopped rising when the government intervened.
The Bank of Japan shocked markets a couple weeks ago when they announced their unlimited government bond buying band would widen from 0-25 basis points to 0-50 basis points. While small in absolute measures, it likely contributed to the U.S. 10-year Treasury yield rising almost 30 basis points in the last nine trading days of the year. If Japanese bonds rise, it would lead to domestic investors selling foreign assets and buying local.
This could be a catalyst for upward pressure on sovereign yields globally. If this causes leveraged players to be forced sellers, you can get some surprising outcomes.
There is likely overconfidence in the bullish fixed income community. Too often positioning and the unwind of leverage are more relevant to asset performance than fundamentals. We remain cautious on corporate bonds as well. Once again, it does not appear that things will be easy to anticipate this year with such a wide range of potential outcomes.
Source: BTC Capital Management, Ibbotson Associates, FactSet, Refinitiv.
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