More Balance in Bonds

Telemus Weekly Market Review April 4th - April 8th, 2022

The first quarter marked the worst quarter for bonds in 42 years. Bond yields began the year at low levels and shot higher on the back of rising inflation and an increasingly hawkish posture out of the Fed. As we enter the second quarter, 2-year Treasury yields have risen from 0.15% a year ago to 2.50% today. Current interest rate levels reflect nine to ten hikes from the Federal Reserve over the next two years.

What’s different today, compared with past rising interest rate cycles, is a more communicative Federal Reserve. Following the Great Financial Crisis in 2008-2009, then Fed Chairman Ben Bernanke ushered in a new policy of more transparent communication, seeking to indicate future Fed intentions well in advance. The logic is that less ambiguity would both make markets more stable and enable them to incorporate future actions into asset prices ahead of the Fed’s actual decision. Over time, the level of transparency has only increased under former Fed Chair Janet Yellen and now Jerome Powell. As we look at markets today, bond yields already reflect a number of future interest rate increases from the Fed, yet thus far they have only increased rates once, by a mere 0.25%. The fact that markets are pricing in this degree of future fed activity is a testament of the Fed’s approach to telegraphing their actions and markets reflecting those expectations.

It is this open transparency that led to the first quarter being so challenging for bond investors. Many economists had projected that the rate of inflation would start to ease going into the new year, with few expecting the added pressure that came from the conflict between Russian and Ukraine. Combined, these surprises led to an abrupt shift in rhetoric from the Fed, which was quickly reflected into bond prices. Hence, there was little time for investors to react.

Looking forward there remains a great deal of uncertainty around the number, pace and cadence of rate hikes the Fed will make. Given comments made by various members of the Federal Open Market Committee, even they don’t pretend to know how much or long the rising rate cycle will be. However, as we look ahead, we believe there is more balance in return outcomes for bond investors. The yield on the 2-year Treasury nearly reflects current Fed forecasts for where they expect their interest rate mechanism, the federal funds rate, to be at the end of 2023. While rates could certainty go higher, at current levels, a 2.5% yield on a 2-year Treasury could withstand another 1.25% increase in its yield before experiencing a negative total return. While the possibility exists for this to happen, its not ours or most Wall Street strategist’s base case. Therefore, the possibility exists for modest positive return out of bonds through the remaining three quarters of the year. Given the nearly -6% drawdown in bond prices in the first quarter a positive return for bonds on the year is less likely in our view.

The path ahead, however, is likely to be anything but steady and smooth. While the Fed is firmly focused on combatting inflation, as the year goes on the magnitude and pace of their actions may become less certain and more data dependent. In addition, along with rate hikes the Fed is also going to be reducing the size of its balance sheet. Given that the Fed has never had anywhere close to $9 Trillion of assets on its balance sheet before, nor have they wound down any more than a few hundred billion, this round of reductions is going to be a first for markets. As markets search to find an equilibrium during this stretch it could lead to some episodes of volatility for yields.

The drawdown in bonds during the first quarter surprised some the past forty-year downtrend in bond yields has largely led to positive returns. In fact, there have only been four negative years for the bond market over this span, so it’s easy to become conditioned to the stable nature of these instruments. As we move forward, while risks remain, there is an opportunity for investors to generate a positive return if interest rates begin to trend near current levels. On an absolute basis yields remain low, however, they are beginning to offer income-oriented investors a bit more current income. Following a trying quarter, investors should begin to view the range of expected returns among bonds to be more balanced going forward.