The Federal Reserve hiked interest rates seven times in 2022 – with more to come in 2023 – and the fed funds rate now sits at 4.25% – 4.50%. Fed Open Market Committee (FOMC) participants see the terminal rate hitting approximately 5.1% by mid-2023, a result of more hikes to combat stubborn inflation. Market rates have responded, with the 2-year treasury sitting at 4.25% in mid-January (it started 2022 at 0.73%). Longer rates have moved higher, too, but are reflecting recession expectations. The 10-year sits at 3.48%, 77 basis points BELOW the 2-year (under normal circumstances the longer-term bond would pay the higher yield). A “2/10” inversion is a historically strong indicator of a coming recession.
Fed Chairman Jerome Powell says slower growth and a softening labor market is the price we’ll have to pay for the Fed’s battle versus 40-year high inflation. But many market watchers feel that interest rates will have to swing lower before too long. “Most of the market seems to think the Fed will over-play their hand,” said Chris Ahrens, a strategist at Stifel Nicolaus & Co. to Advisor Perspectives.
It seems clear that the bond market is positioning itself in front of a hard economic landing. A recession (if it happens) will eventually lead to a plateau at the short end of the yield curve and the Fed pivot that stock investors are desperately waiting for. In this scenario bond fund investors will be receiving a reasonable yield and they will also be in position to take advantage of favorable price movements.
We have been allocating to bonds as a diversifier – they have a history of delivering positive returns when stocks are struggling. Until the exceptional year of 2022, since the introduction of the Barclay’s Aggregate Bond Index in 1976 the S&P 500 and the Agg had never declined in the same year. With yields as low as they have been for the past decade, bond funds have not offered an attractive total return investment opportunity. But in 2022 bond yields defied historical trends by increasing as 1) economic activity slowed, 2) inflation expectations began falling, and 3) Quantitative Tightening began (promoting a “risk-off” environment). Normally, these factors would serve to drive yields lower.
So, are we approaching a yield correction and a buying opportunity in bonds? We think the answer is “yes,” but the operative term is “approaching.” Bond guru Jeffrey Gundlach, founder and chairman of DoubleLine Capital, says bonds are “the place to be.” Due to the fact that bond yields are up 300 basis points or so Gundlach thinks opportunities in fixed income are the best in the last 15 years. He sees bonds as much better holdings than stocks right now on a risk-adjusted basis.
But 2022 was a strange year for bonds. Old trends did not hold. Yields have been wildly unpredictable. As we sit today, we think there’s still a little way to go before it’s the optimum time to commit more to the bond market. But we’re getting close.
By Brian W. Kelly, MoneyLetter Publisher