Telemus Weekly Market Review October 31st - November 4th, 2022
This week the Federal Reserve enacted its fourth consecutive interest rate hike of three-quarters of a percent (0.75%). In a post meeting news conference, Fed Chairman Jerome Powell indicated that rates are likely to trend higher than what was forecast back in September. This led markets to react as yields on Treasury bonds climbed and forecasts for the federal funds rate, the interest rate the Fed controls, now expected to hit 5% (up from 3.82% as of November 4th) during 2023.
As interest rates continue to climb, they will only further challenge year-to-date returns for bonds. Given that bond prices move inverse of interest rates, returns for the asset class have now fallen -16% thus far during 202. This puts the Bloomberg U.S. Aggregate index on pace to mark its worst calendar year since its inception in 1976.
Given the sharp rise in rates, some are beginning to compare the current environment to 1980 when then Federal Reserve Chairman Paul Volker hiked rates aggressively to wipe out what had been persistent inflation. The chart below, produced by BlackRock, highlights how the pace of rate hikes this year has not been as aggressive as what transpired in 1980. It is, however, the second most aggressive rate hiking cycle we have seen since 1972.
Source: BlackRock
The reason Volker had to be aggressive was that inflation had been persistently high for some time. The chart below plots the Consumer Price Index (CPI) from 1970 to 1983. It highlights how in 1980 inflation had consistently exceeded over 5% for seven straight years, including a hyperinflation cycle in 1974 and 1975 when CPI was over 10%+. Thus, the Fed had to be exceptionally aggressive by 1980 to stop the persistent trend. This go around, while inflation has lasted longer than anyone would have liked, we aren’t near the degree of persistence that was in place in 1980.
Consumer Price Index - 1970 to 1983
Source: FRED Database, U.S. Bureau of Labor Statistics
Moreover, what makes 2022 unique to other environments, including 1980, is the starting point. In 1980 yields were much higher. Higher starting yields leave bonds less sensitive to further interest rate moves, helping to dampen the impact of rising rates. This is partially due to the mathematics of how bond prices are calculated. The other component is that the yield is the return you’ll earn if interest rates remain static. If for example, you begin the year with a yield of 10%, which is what the broader bond market offered in 1980, the carry would help to cushion returns against the adverse effects of higher rates. The contrast to 2022, when bond yields began that year at 1.75%, and offered little cushion against rising interest rates.
As we begin to look ahead to a new calendar year and what 2023 might bring, we are cautiously optimistic for bond investors. For starters, bond yields will be starting out at a much higher level, providing greater cushion against any added rate increases. Second, while the Fed clearly indicated they aren’t done and rates are likely to rise into 2023, there are signs that the Fed is starting to make a dent on inflation. Economic activity is easing and beginning to slow demand. Commodity prices have started to level off, easing the raw material and freight costs on manufacturers. Lastly, the pace of wage increases is beginning to ease a sign that expectations are for inflation to dissipate.
While we recognize there are some clear similarities between 2022 and 1980, markets and the economy are in a different place. 2022 has clearly been a challenge for bond investors, but we see a less challenging and more optimistic road ahead.
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