The 2022 Bond Debacle
The first quarter of 2022 has proven to be one of the most challenging beginnings for both the stock and bond markets. Russia’s invasion of Ukraine, heightened inflation here at home, rising fuel costs and stretched valuations have impacted both markets. Investors have learned to expect volatility in stocks over the years. However, the bond market, which many investors consider a “safe haven” where they can protect their capital, has experienced larger than normal losses so far this year.
Forty Years of Downward Rates
Since the early 1980’s, interest rates have continually fallen in our country, giving long-term bond investors a feeling of safety and comfort. Bonds traditionally increase in value as interest rates fall, and their income provides a reasonable total return composed of both income and price appreciation. Bonds should help investors achieve capital preservation, as bonds tend to offset the occasional rapid decline in equities within their portfolios. Yet, according to Barron’s, government bonds are on track to have their worst performance since 1941! So, what went wrong this year?
Keep in mind there is an inverse relationship between bond prices and yields. When yields rise on bonds, prices on existing bonds will fall if sold, and yields are up sharply this year. Bonds have lost $2.6 trillion, about 11%, eclipsing the $2 trillion lost during the 2008-2009 fiscal crisis (Barron’s). From the turn of the year through April 11th, the benchmark 10-year Treasury saw its yield rise to 2.77%, with 54 basis points of the 88 occurring in March alone. This “velocity” of rising rates creates sudden downward pressure on bond prices. If the 10-year Treasury breaches the key level of 3.00% this year, technical analysis suggests further breakouts of rates to the upside.
The benchmark 2-year Treasury yield nearly tripled since the end of 2021, jumping 176 basis points to 2.50% as of April 11th. Should the 2-year yield rise past the 10-year yield that is called an “Inversion”, which is often a leading indicator that the country will soon slip into a recession.
In March, the bond market realized that the Federal Reserve’s long-awaited reversal of accommodation was coming to an end. The Fed took away “the cookie jar” with their March meeting by raising rates 25 basis points and signaling this was just the beginning of several rate hikes to slow down elevated inflation. The market expects the Fed will raise rates six additional times this year and increase rates doubly by 50 basis points in both their May and June FOMC meetings, not just 25 as originally anticipated.
Interest rates moved up sharply in April, when Fed Governor Lael Brainard endorsed the need for the Fed to quickly begin shrinking its balance sheet. Since March 2020, the Fed has doubled the size of its balance sheet to $9 trillion. This infusion of money into the market increased its liquidity, which drove up prices of consumer goods and assets. The FOMC has stated their intentions to reduce the balance sheet by $95 billion per month. According to David Rosenberg of Rosenberg Research, “$95 billion of balance sheet reduction would be the equivalent to an additional 170 basis points increase in interest rates this year.” The Fed is hoping that hiking rates will slow down rampant inflation in the U.S.
Forty Years of Muted Inflation
Last year, numerous Wall Street pros had been sounding the alarm, claiming that the Fed was waiting too long to raise rates while inflation was taking hold. Erroneously, the Fed kept stating that inflation was just “transitory” and would soon begin to retreat. The Fed changed their language at the November 2021 meeting when they dropped the word “transitory” from their remarks regarding inflation.
Now “the cat is out of the bag” with consumer prices up a 7.9% in the past 12-months to a four-decade high, according to Goldman Sachs. Once inflation takes hold in an economy it becomes exceedingly difficult to contain. Back in the 70’s the country experienced high inflation brought about by the Vietnam War, and President Richard Nixon, tried to implement price controls throughout the country on businesses to slow inflation down. Price controls proved to be a dismal failure. Several years later, Fed Chairman Paul Volker told President Jimmy Carter that he could control inflation by harshly raising interest rates to a painful point for the economy and inflation would finally subside. You may remember mortgage rates rose to 17% and one-year CDs were yielding 15% back in 1981.
Eventually, raising rates repaired the economy. Then, after the back of inflation was broken, the country witnessed a decline in rates over the et 40 years. In March 2020, Covid-19 began to ravage the economy. The Fed reacted by dropping rates even further and began purchasing billions of dollars of bonds every month. As a result, the Fed expanded their balance sheet to $9 Trillion, more than double its February 2020 level of roughly $4.2 Trillion. In 2021, rates dropped to historical lows following multiple rounds of stimulus dealt by the Fed. Mortgage rates dropped to 2.5% and the housing market was booming! Savings accounts paid virtually zero percent interest rates and lower income Americans struggled to make ends meet (Yahoo Finance).
This year 2022
The sharp rise in interest rates this year has caused this major weakening in bonds. The iShares
Aggregate Bond Index has a year-to-date return of -7.89% as of April 11th, which is slightly worse than the loss on the S&P 500 at about -7.42%. With the Fed poised to continue raising short-term rates, we may see a flattening of the yield curve, where both short and long-term rates move toward the same level. However, several times throughout the decades we have observed that the bond market, and not the Fed, ultimately decides rates for intermediate and longer-term bonds. Also, we may witness an “inverted yield curve”, in which short-term bonds pay higher interest than longer-dated bonds. According to FundStrat, we have seen 10 yield curve inversions since 1976, and 6 of them have resulted in a recession.
At RMR, we are tweaking our fixed income strategies as the economic cycle further matures and approaches a slower pace of growth, with recovery from COVID now fully in the rearview mirror. The overarching theme of our reposition is derisking, which includes shifting away from longer-term bonds and into shorter duration bonds.
We are adding to short-term bonds for two main reasons. 1) Shorter-duration bonds have less volatility than longer-dated bonds since lower duration bonds (that mature in 1-3 years) will be valued closer to 100 cents on each dollar invested, making them less susceptible to rising rates and price declines. Also, as new bonds come to market at higher yields, short-term bond fund managers can quickly purchase new issues with their rapidly maturing debt.
Seven of the last ten midterm election years have started with negative first quarters for equities (Barron’s). This year the stock market has also had to deal with many other cross currents simultaneously. War, inflation and stretched valuations carried over from lasts year’s terrific performance. The NASDAQ entered “bear” territory after falling over 20%, along with the S&P 500 Index retreating over 12% through early March.
However, as has happened so many times, the stock market reversed course over the past few weeks and rallied strongly! Since the year’s lows on March 14th, the NASDAQ recovered more than 7%, while the S&P 500 recovered about 5.5%. According to JP Morgan, history tells us that the S&P 500 tends to trade in a six-month range of 10%-15% when the Fed begins to raise rates, which happened in 1983, 1994, 2004, 2015, and possibly 2022. Another potential reason for the recovery is that bond investors are leaving bonds and moving into stocks amid the bond markets continued struggle.
In line with our fixed income changes, we are also derisking our equity allocations. We have trimmed back our U.S. Small Cap and Emerging Markets targets, while increasing our exposure to U.S. Large and Mid Cap stocks. These moves represent our conviction in larger, higher quality companies, including Mega Cap Technology names, which are trading at attractive prices after the selloff that occurred up until mid-March.
As always, please feel free to contact your RMR advisor should you have any questions regarding your account(s).
RMR Investment Committee