- Bond markets have seen a dramatic change in 2022 as interest rates moved significantly higher.
- While rates retreated modestly in mid-summer, bond yields were on the rise again by late August.
The interest rate environment changed dramatically in 2022. While the benchmark 10-year U.S. Treasury note yielded 1.5% at the end of 2021, the yield topped 3% by May. In June, the 10-year Treasury yield reached its highest level in 11 years, 3.485%.1
Investors generally considered this a negative development because of the inverse relationship between bond yields and bond prices. When yields rise, prices of bonds already in the market fall. This is a function of supply and demand. When demand for bonds declines, issuers of new bonds must offer higher yields to attract buyers, reducing the value of lower-yielding bonds already on the market. This environment hit bondholders hard in the opening months of the year.
Interest rates tend to follow long-term growth and inflation trends. Higher inflation often means higher interest rates. As inflation rates rose throughout 2021, however, the bond market appeared to have a delayed reaction. A variety of developments, from continued supply constraints for major goods to a major shift in monetary policy by the Federal Reserve (the Fed) and Russia’s invasion of Ukraine, altered the landscape for investors in 2022.
Aggressive stimulus measures in 2020 and 2021, rising demand for goods and services, and supply chain disruptions contributed to a surge of inflation. The Consumer Price Index (CPI) reflected the changing landscape, rising by 9.1% for the 12-month period ending in June, its highest reading since 1981, before decelerating slightly to 8.5% in July.
“Bond yields rose primarily because the Fed pivoted to a much more hawkish position, as investors anticipated aggressive interest rate hikes to rein in inflation,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. Merz notes that bond markets tend to move in advance of specific Fed actions, often anticipating upcoming monetary policy moves.
The Fed’s influence on interest rate markets
The Fed can increase short-term interest rates as a tool to dampen inflation by reducing loan demand and cooling the pace of economic activity. Fed Chairman Jerome Powell and other members of the policy-making Federal Open Market Committee (FOMC) made clear that the Fed’s “easy money” policies from 2020-21, which included maintaining a near 0% federal funds target rate (a short-term interest rate the Fed controls), had to change in response to the inflation threat.
From March through July 2022, the Fed raised the fed funds rate by 2.25%, a dramatic turn of events. Powell, in a public statement on August 26, 2022, stated, “Restoring price stability will likely require maintaining a restrictive monetary stance for some time.” According to Merz, Powell was clearly stating the Fed will lean in the direction of further interest rate hikes until there is more convincing evidence that inflation has receded.
“Our emphasis is on high-quality investment-grade taxable and municipal bonds to manage overall risk exposure should interest rates continue to rise in the near term.”
- Bill Merz, head of capital markets research at U.S. Bank Wealth Management
“While Chairman Powell’s message wasn’t much different from his previous comments, investors appeared to finally hear his message and believe it,” says Merz. “Prior investor expectations that the Fed might cut rates by mid-2023 moderated considerably.” Notably, the stock market suffered a significant setback after this statement and bond yields began to move higher, reversing a short-term pullback.
A flatter yield curve
Another trend is the unusual interest rate environment along the yield curve representing different bond maturities. Under normal circumstances, bonds with longer maturity dates yield more, dubbed an upward sloping yield curve. This state reflects a return premium for the greater uncertainty in lending money for a longer time. 2022 has been an unusual period where yields along the maturity spectrum have narrowed, reflecting a “flattening” of the yield curve.
In some cases, yields between different maturities inverted, meaning the yields paid on shorter-term securities are higher than those offered on longer-term maturities. “Historically, such trends indicate lower-than-average performance in the stock market (as measured by the Standard & Poor’s 500 Index) and an uptick in the unemployment rate over the next year,” says Merz. “It’s one signal suggesting that investors should pursue a defensive approach to markets in the near term.”
The Fed’s progress and ongoing hurdles
After year-over-year inflation peaked in June, slightly more favorable news emerged. July’s CPI figure decelerated from 9.1% to 8.5%. “Decelerating year-over-year inflation is constructive,” says Merz, “but we need to see much more before the Fed changes its policy approach.”
Merz also notes that there’s a lag time between when the Fed puts interest rate policy into place and its impact on the broader economy. “Many economists believe the economic impact is felt 12-18 months after a change in interest rate policy, though some believe that lag is shorter,” says Merz. “We expect the Fed will continue increasing rates in the coming months, so recent and future rate hikes still may not flow through to dampen economic activity for some time.”
Merz expects inflation to continue decelerating but elevated enough to keep pressure on the Fed to maintain high interest rates. For example, shelter costs make up a significant portion of CPI. Merz says there tends to be a lag before changes in housing prices show up in the inflation data. “Home prices rose considerably until recently, and that’s still to be reflected in CPI. In the past few months, higher interest rates have led to decelerating home prices. That’s not yet incorporated in the CPI numbers,” notes Merz.
External events can also impact inflation trends. A prime example in the current environment is the Russian invasion of Ukraine. Russia is a major energy producer, particularly for Europe, while both countries are significant agricultural exporters. The conflict has affected the flow of oil, natural gas and food products. With supplies reduced, oil consumers push prices higher. “That’s outside the control of central banks,” says Merz. “Interest rate hikes by the Fed, the European Central Banks and others are meant to slow demand, but they don’t improve supply.”
Issues such as the war, the emergence of another overseas conflict or a resurgence of COVID-19 or other public health issues could contribute to an economic slowdown. “It’s more of a balancing act because of the war,” says Rob Haworth, senior investment strategy director at U.S. Bank. “Along with watching inflation trends, the Fed will also be keeping an eye on whether consumer spending falters.” If there are further economic ramifications because of the conflict in Eastern Europe, the Fed’s monetary policy may have to adapt.
Does the Fed’s current policy mean that interest rates will continue trending higher as they have for most of 2022? Merz says the most recent comments by Chairman Powell are a sign the bond market may need to price in more Fed rate hikes than initially anticipated, but slowing economic growth should eventually keep a lid on longer-term bond yields.
Even as the yield on 10-year Treasuries lingers above the 3% level, it’s still in a historically low range. For most of the past decade, yields ranged between 2 and 3%. 10-year Treasuries have not generated a yield of as high as 4% since 2010.2 “We expect the inflation rate to ease over the course of 2022 and 2023,” says Haworth, “but still be far above the Fed’s long-term goal of a 2% inflation rate (as measured by the CPI).”
Finding opportunity in the bond market
As yields across the bond market trend higher, what are the best options for bond investors? The recent rise in interest rates means investors buying bonds now will receive higher yields. “We’re putting greater emphasis on core bond holdings,” says Merz. “We believe that bonds offer compelling defensive characteristics relative to stocks.” Specifically, he recommends both taxable bonds and, where appropriate, tax-exempt municipal bonds as reasonable positions for portfolios today. “Our emphasis is on high-quality investment-grade taxable and municipal bonds as well as a dedicated exposure to short-term U.S. Treasury investments to manage our overall risk exposure should interest rates continue to rise in the near term,” says Merz.
There is an important potential benefit for bond investors who concentrate more of their bond positions in high-quality segments of the fixed income market. “This is a way to add diversification to help manage risks in a portfolio that includes equities,” says Merz. While 2022 has so far proved to be a rare occasion where both stocks and bonds declined in value, Merz believes that over the long run, holding high-quality bonds will typically help smooth volatility in an investor’s diversified portfolio.
Additionally, investors may wish to consider other aspects of the fixed income market that offer unique potential. “We still see opportunities in strategies like insurance linked securities, also called reinsurance, which is uncorrelated to traditional stock and bond investments.” These are investments that provide financial backing of the risks taken by insurance companies. Merz notes that the yields offered on reinsurance products are very attractive in today’s environment.
While Treasury Inflation Protected Securities (TIPS) might seem to be an appealing option in a high inflation environment, Merz is less enthusiastic. “We do not explicitly suggest TIPs due to low absolute return expectations,” he notes. They can, however, provide benefits as a small part in some investors’ portfolios. Merz notes that TIPS offer minimal credit risk and the potential for relative outperformance over standard Treasury securities if inflation is higher than what investors currently price in bond markets.
Merz believes the primary opportunities for bondholders in today’s environment are in higher-quality securities, including Treasury bonds and investment-grade corporate bonds. “This is a period when investors are likely to benefit from holding more high-quality assets and fewer volatile assets than in a typical period.”
Talk to your wealth professional for more information about how to position fixed income investments as part of a diversified portfolio.
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