Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, December 20, 2022
Many financial markets are on pace for their worst year in quite some time, or in the case of core bonds, the worst year since inception of the Bloomberg Aggregate Bond Index, which is the main core bond index. With inflationary pressures running much hotter than central bank targets, many central banks were forced to respond by raising policy rates at a speed and magnitude unlike any other year, which was a decided headwind to many financial assets this year.
As mentioned in this week’s Weekly Market Commentary (found here), the Fed’s 0.50% rate hike last week capped a year in which the Federal Reserve (Fed) raised short-term interest rates at the fastest clip in four decades. Moreover, the magnitude of rate hikes brought the fed funds rate to its highest levels in over a decade. However, we think most of the rate increases have either already taken place or (mostly) priced into market’s expectations at this point. And since we’re starting to see positive signs of inflationary pressures easing, it is likely the Fed can step down the pace and magnitude of rate hikes in 2023 and perhaps even pause rate hikes, which could be welcome news for core bonds.
Historically, core bonds have performed well during Fed rate hike pauses. Since 1984, core bonds were able to generate average 6-month and 1-year returns of 8% and 13%, respectively, after the Fed stopped raising rates. Moreover, all periods generated positive returns over the 6-month, 1-year and 3-year horizons.
While we don’t think monetary policy will become accommodative anytime soon—absent a financial crisis or deep recession, which isn’t our base case—the central bank headwind that took place in 2022 may not be as strong in 2023, which could help many financial markets in 2023. This year will most certainly be the worst year for core bonds on record and it will take time to recover the price declines experienced this year. However, while there is certainly no guarantees that history will repeat or even rhyme this time, the back-up in yields, for many fixed income markets, provides an attractive opportunity, in our view.
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