From the early days of Ronald Reagan’s first term in the White House, the bond market was in rally mode with only a few brief interruptions, as falling yields led to rising fixed-income prices. While a reversal of fortune was likely inevitable, few knew at the start of 2022 that the 30-year rally would come to such a violent end.
“The fixed-income returns we’ve seen this past year are close to the worst on record,” says Neil Sutherland, a portfolio manager at Schroders. The silver lining: Bond prices have moved lower and yields are up. “That suggests we’re looking at better values than we’ve seen in quite some time,” he adds.
That’s not to say that fixed-income investors should expect smooth sailing ahead. While we’ll likely see inflation fall from recent peaks, it will be a while before we know how quickly price pressures will cool, and equally important, by how much.
If inflation does trend lower and moves back below 5% this winter, then the Federal Reserve may not need to raise interest rates as high as some have feared. That could help pave the way for a proverbial “soft landing” for the U.S. economy.
What would constitute a soft landing? Unemployment rates, which currently sit below 4.0%, would rise toward the 4.5% to 5.0% range, but no higher, and that rate could sustain current levels of consumer spending. And in such a soft landing/modest recession scenario, companies would be more likely to maintain ongoing capital spending plans while keeping layoffs to a minimum.
Yet inflation has remained stubbornly persistent, notes Scott Barnard, a portfolio manager at Westwood. If metrics like the Consumer Price Index fail to show a steady decline, the Fed may need to raise interest rates for a longer stretch, perhaps to the point where economic activity contracts into a deep recession.
The rapid rise in global interest rates already is roiling markets as diverse as housing, autos and pensions. In these circumstances, the likelihood that “something will break” increases significantly, Barnard says. “Look at the U.K.”
Last month, the Bank of England was forced to inject liquidity into the bond market after U.K. pension funds deploying so-called liability-driven investing strategies were hit with margins calls. In addition to those challenges, Sutherland adds that the “surging dollar may also bring unintended consequences to the bond market.”
If the economy and markets continue to weaken, investors will also need to consider the “misery index,” which combines the inflation rate and the unemployment rate. Bond management firm PIMCO noted in a recent year-ahead outlook that a rising misery index would portend “a stagflationary shock that will probably hinder the U.S. economy at a time when it is also dealing with some of the fastest tightening in financial conditions since the 2008 financial crisis, generally low consumer and business sentiment, and elevated uncertainty.” All this raises “the risk of a harder landing for the U.S. economy.”
Sutherland thinks it will be pretty difficult for the Fed to engineer a “soft landing.” If a serious recession unfolds, Barnard believes that longer-term bonds would rally significantly as growth and inflation expectations start to diminish.
Missing the mark on inflation isn’t the only reason that the Fed’s credibility is suspect. At the start of 2022, the central bank predicted real GDP in the U.S. would come in at about 4.0%. Now that figure looks likely to be closer to 1.0%, Barnard says.