Fixed Income Outlook: Bonds Are Back
It has been a long time coming, but 2023 looks to be the year that bonds will be back in fashion with investors. After years of low yields followed by a brutal drop in prices during 2022, returns in the fixed income markets appear poised to rebound. It's likely to be a bumpy ride due to the cross currents created by global central banks' tightening policies, a volatile global economy, and ongoing political uncertainty here and abroad. Despite these challenges, we see opportunities in 2023 for the bond market to provide investors with attractive yields at lower risk than we've seen for several years.
Source: Schwab Center for Financial Research. For illustrative purposes only. Investing in bonds involves risk, including loss of principal. Consider your individual circumstances prior to investing.
We look for the Federal Reserve to end its rate hikes in early-to-mid 2023 amid a soft, perhaps recessionary, economy that brings inflation lower. The yield curve is likely to remain deeply inverted as monetary policy remains tight. Assuming the Fed sticks to its tight policy stance at the expense of economic growth, ten-year yields could fall as low as 3%. With that backdrop, we favor adding duration to bond portfolios during periods of rising rates, while staying up in credit quality.
2022: The great reset
In 2022 the bond market went through a huge resetting of interest rates. Coming into the year, short-term interest rates were still near the pandemic-era low of close to zero. The Federal Reserve began a gradual shift to tighter monetary policy with a 25-basis-point rate hike in March 2022 as economic growth recovered. Gradualism soon gave way to rapid tightening by summer as inflation surged on the back of supply/demand imbalances, a resilient economy, and the spike in oil prices due to the war in Ukraine.
In all, the pace of rate hikes has been the most rapid in modern times.
The pace of Fed rate hikes in this cycle has been rapid
Federal Funds Target Rate - Upper Bound (FDTR Index), using monthly data. Current cycle as of 10/31/2022. Note: Data is the short-term interest rate targeted by the Federal Reserve's Federal Open Market Committee (FOMC) as part of its monetary policy. Lines represent the cumulative change in the Fed funds target rate from the start of each rate hike cycle shown. Past performance is no guarantee of future results.
With starting yields low and the rate of change in tightening so fast, nearly every segment of the fixed income markets experienced declines, especially bonds with long durations. In fact, performance in 2022 year to date has been an anomaly. Even in past periods of sharply rising interest rates, bonds have usually delivered positive returns since the income from a bond's coupon offset price declines. However, during 2022, without the cushion of high coupon income, returns were historically weak.
Negative returns have been uncommon in a diversified fixed income portfolio
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc.
Shown in the chart are annual total returns including price change and income for the Bloomberg US Aggregate Bond Index. Returns include reinvestment of interest. Indices are unmanaged, do not incur fees or expenses, and cannot be invested indirectly. For additional information, please see Schwab.com/Index Definitions. Past performance is no guarantee of future results. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. For illustrative purposes only *YTD as of 9/27/2022.
2023: The tide turns
Our optimism about returns for 2023 is based on three factors:
- Starting yields are the highest in years—in both nominal and real terms;
- The bulk of the Fed tightening cycle is over; and
- Inflation is likely to decline.
After a long drought, the bond market is awash in yields that are attractive relative to other income investments. A portfolio of high-quality bonds—such as Treasuries and other government-backed bonds, and investment-grade corporate bonds—can yield in the vicinity of 4% to 5% without excessively high duration. Tax-adjusted yields in municipal bonds are also attractive for investors in higher tax brackets. In addition to the relatively attractive yields, higher coupons for newly issued bonds should help dampen volatility.
Yields in fixed income investments are well above dividend yields for the first time in several years
Source: Bloomberg, as of 12/02/2022 versus 12/31/2021.
Indexes represented are: Bloomberg U.S. Aggregate Bond Index (U.S. Aggregate), Bloomberg U.S. Corporate Bond Index (IG Corporates), Bloomberg U.S. Corporate High-Yield Bond Index (HY Corporates), Bloomberg U.S. Municipal Bond Index (Municipal Bonds), ICE BofA Fixed Rate Preferred Securities Index (Preferreds), Bloomberg Emerging Market USD Aggregate Index (EM USD Bonds), Bloomberg U.S. MBS Index (MBS), Bloomberg U.S. Treasury Index (Treasuries), and the S&P 500 Dividend Aristocrats Index (Dividend Aristocrats). Yields shown are the average yield-to-worst except for the Dividend Aristocrats which is the average dividend yield. Past performance is no guarantee of future results. For illustrative purposes only. Indices are unmanaged, do not incur fees or expenses, and cannot be invested indirectly.
Yields have not only moved up in nominal terms, but in real terms as well. (Real yields are nominal yields adjusted for inflation expectations.) Two-year Treasury real yields now exceed the 2019 peak level, while five- and 10-year real yields are at the highest levels since 2009. High real yields in risk-free Treasuries mean investors don't have to look to riskier segments of the market for returns that will beat inflation. Moreover, by raising the cost of capital to businesses and households, high real yields tend to slow economic growth.
Real yields are the highest since 2009
US Generic Govt TII 2 Yr (USGGT02Y INDEX), US Generic Govt TII 5 Yr (USGGT05Y INDEX), US Generic Govt TII 10 Yr (USGGT10Y INDEX). Daily data as of 12/05/2022. Past performance is no guarantee of future results. For illustrative purposes only.
Fed policy: Hike, hold and … ?
Comments from Fed officials signal that they plan to keep hiking rates in early 2023, albeit in smaller increments than this year. Now that the federal funds rate is approaching a level considered restrictive—high enough to slow growth and inflation—it will likely reduce the size of rate hikes. The market is discounting a 50-basis-point rate hike at the December meeting and then two 25-basis-point rate hikes at the following meetings in the first quarter, bringing the target range for the fed funds rate to 4.75% to nearly 5%. That seems reasonable to us.
Market is pricing in a peak fed funds rate of nearly 5% and a decline in late 2023
Market estimate of the federal funds target rate using Fed Funds Futures Implied Rate (FFM2 COMB Comdty). As of 12/02/2022 For illustrative purposes only. Futures and futures options trading involves substantial risk and is not suitable for all investors. Please read the Risk Disclosure for Futures and Options prior to trading futures products. Futures accounts are not protected by SIPC.
Note that the market is discounting the likelihood of rate cuts by the end of 2023, but Fed officials are indicating that they plan to hold rates high for "a while longer" until they are confident that inflation is heading to the 2% target. That difference—between what the market is pricing in and what the Fed is signaling—is the key to the direction of yields for much of the year. If the Fed holds the federal funds rate near 5% or above all year, then it's likely that longer-term yields will experience bouts of volatility with 10-year Treasury yields potentially retesting the 2022 highs in the 4.25% to 4.5% region.
However, we lean toward the market view that by late 2023, the Fed will likely be cutting rates. By mid-year, the aggressive rate hikes to date should result in weaker economic growth and falling inflation, pulling long-term yields lower. Historically it has taken six to 18 months for the impact of higher interest rates to show up in economic data. Given the "front loading" of rate hikes since March, the economy is only beginning to feel the impact of tightening.
Wholesale goods prices have been falling sharply over the past year. On a year-over-year basis, producer prices for crude goods have dropped by 5%, while intermediate and finished goods prices are also starting to soften. This "disinflation in the pipeline" will likely work its way through the economy, pulling overall inflation lower.
Disinflation is in the pipeline
U.S. Producer Prices Index U.S. PPI Unprocessed Nonfood Materials Less Energy (PPICXYOY Index), U.S. Producer Prices Index Processed Goods For Intermediate Demand (PPIITYOY Index), U.S. Producer Prices Index Finished Goods (PPIYOY Index), NSA (not seasonally adjusted), YoY%. Monthly data as of 10/31/2022. The U.S. Producer Price Index is a measure of the change in the price of goods as they leave their place of production. Shown in the chart is the year over year percent change for each index.
The steep inversion of the yield curve (that is, the difference between short-term and longer-term yields), which has historically been a reliable signal of recession in a year's time, also suggests that credit availability is tightening which generally leads to slower growth.
3-month / 10-year yield curve is inverted
Source: Market Matrix US Sell 3 Month & Buy 10 Year Bond Yield Spread (USYC3M10 Index).
Daily data as of 12/05/2022. Note: This spread is a calculated Bloomberg yield spread that replicates selling the current 3 month U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. One basis point is equal to one one-hundredth of a percentage point, or 0.01%. Past performance is no guarantee of future results.
2-year / 10-year yield curve is inverted
Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USCY2Y10 INDEX). Daily data as of 112/05/2022. Note: The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. Past performance is no guarantee of future results.
Moreover, this has been a synchronized global tightening cycle, led by the Federal Reserve. A wide range of central banks throughout the developed and emerging world have been hiking rates to fight inflation and support their currencies. Consequently, excluding the COVID-19 crises, global gross domestic product (GDP) growth is running at its slowest pace since 2009 and the dollar recently hit a 20-year high. A strong dollar tends to dampen inflation by reducing the cost of imports and slowing exports.
Both import and export prices declined on a year-over-year basis
US Import Price Index by End Use All YoY NSA (IMP1YOY%) and US Export Price By End Use All Commodities YoY NSA (not seasonally adjusted) (EXP1CYOY Index). Monthly data as of 10/31/2022.
Finally, the Fed has also ramped up its quantitative tightening program—the process of allowing its balance sheet to shrink by up to $95 billion per month. The aim is to reduce it by about $2.5 to $3 trillion over the next few years, bringing it down to pre-pandemic levels relative to GDP. Quantitative tightening is designed to work through several different channels. The most powerful, in our view, is that it signals that money is getting tighter. When combined with higher interest rates, the signal leads investors to reduce risk.
The Fed's balance sheet
Reserve Balance Wednesday Close for Treasury Bills, Treasury Notes, Treasury Bonds, Treasury Inflation Protected Securities (TIPS), and Mortgage Backed Securities (MBS). Weekly data as of 11/30/2022.
The key to the direction of Fed policy, however, is in the labor market. Fed Chair Jerome Powell has made it clear that the Fed wants to see a "looser" labor market with slower growth in wages, as the Fed is worried that rising wages will lead to persistently high inflation. The rebalancing of the labor market has lagged in rebalancing compared to other areas of the economy. The supply of workers has been held back by a variety of factors, including COVID-related health issues as well as lack of immigration while demand has stayed firm. Consequently, as the economy rebounded from the pandemic, wages reset higher in the last year to draw more workers back into the labor force.
Looking into 2023, we expect the pressure on wages to ease. Wage growth already appears to have peaked and is starting to decline. Average hourly earnings have slowed to a 5.1% year-over-year pace from 5.6% in March. As economic growth slows, wage growth will likely continue to retreat. Our guess is that the Fed would like to see wage growth in the 2% to 3% region—where it was before the last tightening cycle began.
Wage pressures remain
Source: Bloomberg, using monthly data as of 8/31/2022. US Average Hourly Earnings All Employees Total Private Yearly Percent Change SA (AHE YOY% Index). Note: Pre-pandemic average 2.7% date range 10/31/2015-1/31/2020.
Holding for longer?
Fed officials have repeatedly referenced the policy mistakes of the 1970s as a reason to keep interest rates high even after inflation has started to fall. They want to avoid easing too early because it might allow inflation to rebound and inflation expectations to become embedded, leading to a wage-price spiral. We don't believe that the current period is a repeat of the 1970s, but since that's the Fed's view, we have to take it into consideration in making a forecast for Fed policy.
To date, inflation expectations have remained low considering the high level of current inflation. Market-based measures such as the yield spread between Treasury Inflation Protected Securities (TIPS) and nominal Treasuries show expectations of about 2.5%, while survey-based readings show long-run inflation expectations near 3%. Both measures have declined since the Fed started hiking rates—a sign that the market believes the Fed will succeed in holding down inflation long-term.
Inflation expectations have receded
U.S. Breakeven 10 Year (USGGBE10 Index) and U.S. Breakeven 5 Year (USGGBE05 Index). Daily data as of 12/05/2022.
On the flip side, the Fed also focuses on financial stability.
In our view, the conditions that would warrant a rate cut by the end of 2023—recession, declining inflation, and slower wage growth—are the most likely scenario. Consequently, our expectation is that a rate cut near the end of 2023 is likely.
Risks to our view
The major risk to our view would be a resurgence in inflation. It could materialize from a more-rapid-than-expected reopening of China's economy from its COVID lockdown policies, a spike in wholesale goods prices due to the Russia-Ukraine war, a stronger-than-expected pace of consumer spending domestically, or a sharply weaker dollar. These are factors we are watching but given the amount of global tightening in monetary policies year to date, the risks appear skewed to slower growth and inflation.
What investors can consider now
We are optimistic about returns in the fixed income markets in the year ahead. Yields are starting at the highest levels in years, and the bulk of the rate hikes for this cycle appear to be behind us. Economic growth is slowing, and inflation is abating in response to the rapid pace of tightening by central banks, allowing room for long-term yields to fall.
Ten-year Treasury yields could rebound toward the 4% level at times if inflation surprises hit, but by year end yields should be closer to 3% to 3.25%. That spells the opportunity to invest for income and potential capital gains. We suggest investors continue to increase duration, keeping the average near an investor's long-term benchmark.
We are cautious about taking too much credit risk in the face of slowing economic growth or recession. Current yields on riskier bonds, such as high-yield bonds, don't provide extra compensation for the extra risk, in our view. That may change as the year progresses, but for now we are neutral.
Volatility is likely to remain elevated as markets transition from a zero-interest-rate world to one with high real rates and heightened geopolitical risks. But our message is one of optimism for bond investors.