Despite high volatility in the bond market during the first half of the year, what's surprising is how much didn't change.
It hasn’t been an easy start to the year for bond investors. The Federal Reserve continued its aggressive pace of rate hikes; instability flared in the banking industry, requiring government intervention; and a tense battle over raising the debt ceiling led to heightened fears that the U.S. government might default. Not surprisingly, volatility in the bond market—which is a measure of the degree of uncertainty about the direction of interest rates—soared during the first half of the year.
Yet as we close the books on the first half of 2023, what stands out is how much didn’t change. Short-term yields have pushed higher as the Fed tightened policy, but yields for Treasury securities maturing in two years or more are nearly unchanged.
The yield curve remains inverted, but the spread between 2-year and 10-year Treasury yields has stabilized in a range after plunging to its deepest level in decades.
Despite all the turmoil in the market, year-to-date returns have been positive in nearly every sub-asset class of the fixed income market. Short-term investments with low durations posted modest gains, while intermediate- to long-term bonds benefited from higher starting coupons and a downward drift in yields.
The Fed continues to follow its “hike and hold” strategy to fight inflation. It raised rates rapidly over the last year, bringing the federal funds target rate to 5.0% to 5.25%, the highest level since 2007. In the second half of the year, the Fed is signaling it will likely shift to holding rates steady and only increase them gradually if inflation remains persistent.
The shift to a more gradual tightening stance reflects growing confidence that policy is succeeding. Economic growth is slowing, and inflation is easing. Gross domestic product (GDP) growth has averaged less than 1.5% over the past four quarters, the manufacturing industry appears to be in recession, and housing activity has fallen sharply. The service industry has proven more resilient, but the pace of growth is easing.
On the inflation side, a key concern has been the strength in wage growth, which the Fed believes can contribute to inflation, becoming embedded. The recent trend indicates that wage pressures from a tight labor market appear to have peaked. Average hourly earnings are running at a 4.3% pace compared to a peak of almost 6% late last year, indicating that the supply of labor is beginning to balance out with demand after the pandemic-related shortages. Wage growth is probably still too high for the Fed’s comfort level. A growth rate that prevailed prior to the onset of the pandemic of about 2.5% to 3.0% would likely be seen as pointing to a stable inflation outlook.
While the Fed may cease or slow its rate hikes, it is still in tightening mode. The federal funds rate is higher than the current rate of inflation as measured by the Fed’s preferred indicator, the core Personal Consumption Expenditures (PCE) index. Policy is now in the restrictive range, which should mean slower growth and lower inflation ahead. Real yields—that is, yields adjusted for inflation expectations—are at the highest levels in years, making it more expensive to borrow for investment or consumption. This is the point of tight monetary policy: to reduce inflation by slowing down the economy.
However, the Fed won’t likely switch to rate cutting until inflation is closer to its 2% target. Based on its benchmark measure—the price index for PCE excluding food and energy—there is still a long way to go, and it has been stuck near 4.5% for several months.
The good news is that the “stickiness” in inflation is now confined to a smaller number of categories compared to earlier in the year. In recent months, three categories largely accounted for above-average inflation—housing, financial services, and used cars. As the categories of price inflation narrow, the overall trend will likely improve.
The New York Federal Reserve Bank recently published a way to measure the “persistence” of inflation. Its model suggests that inflation pressures may ease later in the year. Of course, it’s just a model, and the Fed isn’t likely to weigh it heavily in the bank’s decision making, but it’s suggesting the trend is lower.
The Fed is also continuing to tighten monetary policy by allowing the size of its balance sheet to shrink as the bonds on its balance sheet mature. All indications are that the plan is to let the process continue even if rate hikes end.
There is a lot of speculation about the Fed’s moves in the second half of the year. If rate hikes are paused, does that imply the cycle is over … or is it just “skipping” a meeting and then resuming hikes? Or will the Fed actually need to increase the size of its rate hikes—a jump—to catch up to inflation?
We look for the Fed to keep its policy stance largely on hold in the second half of the year, although one more rate hike is possible. A shift to easing policy would only likely be seen if the economy were to fall into recession or if financial stability issues were to re-emerge. Overall, we believe the federal funds rate is at or near its peak for this cycle and that intermediate- to long-term rates peaked last fall.
Because the economy responds to changes in Fed policy with a lag, the risks to growth and inflation appear skewed to the downside after more than a year of tightening policy. Moreover, fiscal policy has gone from a positive factor for the economy to a negative one. The “fiscal impulse,” which measures the contribution of fiscal policy to GDP growth, has shifted to a slight negative after surging during the pandemic.
In the second half of the year, we look for bond yields to continue to decline. The forces that have been pulling them lower—tightening monetary and fiscal policies—should continue. Treasuries with maturities of two years or longer likely will continue to decline. We expect to see 10-year Treasury yields fall to the 3.0% to 3.25% level by year-end. The yield curve will likely remain inverted until there is a signal that the Fed is shifting to easier policy.
Our guidance for investors is the same as it has been since late last year: Consider adding some intermediate-term or longer-term bonds to portfolios gradually and stay in higher-credit-quality bonds. While it may be tempting to stay in very short-term investments due to risk-free yields at 5% or higher, that opens investors up to reinvestment risk—the risk that they will have to reinvest maturing securities when yields are lower.
With current yields in the region of 4% to 5% for high-credit-quality bonds like Treasuries, other government-backed bonds, and investment-grade corporate and municipal bonds, we think it makes sense to lock in those cash flows with certainty rather than risk reinvesting maturing short-term bonds into lower yields once the Fed begins to cut interest rates.
Moreover, there is also likely potential for capital gains for investors with shorter time horizons. In past cycles, the total return for intermediate-term bonds has been higher than in short term in the 12 months following the peak of the federal funds rate.
While our expectation is that inflation will recede, many investors remain concerned about inflation. In that case, it might make sense to consider Treasury Inflation Protected Securities (TIPS) as an alternative or in addition to nominal Treasuries. Yields are roughly 1.5% or more in real terms. That means an investor who holds to maturity can expect to receive the real rate plus the rate of inflation based on the Consumer Price Index (CPI). Consequently, if inflation does prove more persistent than current trends suggest, TIPS can offer investors a way of mitigating that risk in their bond portfolios.
In sum, we look for returns in the second half of the year to be positive even if Federal Reserve policy stays the same as it has been in the first half. We’re just hoping for a lot less volatility along the way.
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