Bottom Line: Here at APCM we believe the worst of the negative returns in fixed income are behind us. Moving forward we expect less interest rate volatility even as the market continues to digest the economic challenges ahead with inflation and economic growth, and uncertainty if the FOMC will be able to manage a soft landing.
Yields on the 10yr and 30yr bonds have dramatically increased 1.50% and 1.28%, pushing total returns on those bonds down -11.51%, and -23.81%, respectively. Bond prices started to fall at the beginning of the year as markets priced in interest rate increases and there was not much yield (coupon return) to cushion the price declines. Current yields are over 2% higher than at the start of the year, so any further price declines will be offset in part by the higher yields (coupon income).
Three main drivers will determine how interest rates behave: the trend in inflation, the level and trend of economic growth, and Fed Policy. On the inflation front, CPI is currently at 8.6% year-over-year. The next CPI print is on Wednesday, July 13th. The survey of economists is showing a new CPI of just 8.8%. We continue to watch Services inflation which makes up 57% of CPI and wage growth. Current levels of inflation are near 9%, while most parts of the US Treasury curve are around 3%. This is an exceptionally large gap, you can get higher rates even with lower inflation, but not in isolation – you also must consider economic growth.
The economy is entering challenging times. We continue to believe that the economy will move forward albeit on a bumpy road. The consumer (70% of GDP) continues to spend above pre-Covid trends at the cost of personal savings. Credit can help offset this, but with higher borrowing costs the demand for credit will be less. Unemployment continues to remain low at 3.6% and could increase moderately. More than a 1.0% increase has triggered every recession since 1980. There remain challenges to the US economy via supply chain disruptions, slowing business spending, and sentiment.
The Federal Reserve has direct control over the front end of the yield curve. At the beginning of the year, markets were pricing six price hikes with a year-end Fed Funds at 1.50%. Today, we are already at 1.50%, with another six price hikes expected and a year-end target of 3.00%. The Federal Reserve continues to balance the fight against inflation vs slowing the economy too much. If the Federal Reserve raises the Fed Funds rate to levels where credit demand slows considerably, it could cause the US economy to falter and enter a recession. The sweet spot for the Fed is to raise the Fed Funds rate just enough to slow inflation but not do any harm to the credit cycle.
Within the Fixed Income group, we are structuring portfolios with the position that short-end yields will continue to rise alongside Fed Funds Rate, but not in lockstep. We anticipate flat yield curves in the quarters ahead. For longer-term rates to bounce and move above shorter-term rates, growth will have to surprise to the upside, a challenging outlook over the near term, with the Fed’s intent to weaken demand in the economy.
That said, we believe the worst of the negative returns in investment-grade fixed income is likely behind us. Under our base scenario of low growth and moderating inflation, the historical negative returns that were experienced in the first half of the year should not be duplicated in the second. There continue to be challenges ahead with inflation, weaker economic growth, and uncertainty if the FOMC will be able to thread the needle on rate hikes – but such financial uncertainty creates an attractive environment for stable income assets. With bonds yielding significantly more than in January – these assets are again filling a void for conservative investors looking for a stream of income.
Bill Lierman, CFA®
CIO – Fixed Income