The bond market doesn’t generally attract much attention, but when there's a big move, it’s worth taking a look.
In this case, 2021 has started off with a swift slide in bond prices and a resulting jump in bond yields. Last week, the yield on the U.S. Treasury 10-year note, a key market benchmark, jumped to 1.87% (its loftiest level since the start of the pandemic) from 1.52% at the end of 2021. To put this move into perspective, some on Wall Street had predicted a rise in yields of this size for the entire year.
The declines in the bond market have been broad-based, with the Morningstar U.S. Core Bond Index losing 2% so far in 2022. This follows on the heels of 2021's 1.6% decline in the index, which was the largest since 2013 when the index lost 1.95%. These losses in bonds have rippled over to the stock market, contributing to its own rocky start to the year.
The fact that rates have been on the rise in 2021 is not a surprise, analysts say. By historical standards, bond yields have been exceptionally low, especially compared with the strength of the economy and inflation.
“It’s not surprising that we’re seeing rates go back up,” says Daniel Kemp, global chief investment officer for Morningstar Investment Management. Rates “were a long ways from normal.”
But as with the sudden turn in stocks to kick off 2022, the speed and extent of the rise in bond yields caught many in the market off-guard.
Collin Martin, fixed-income strategist at Charles Schwab, says that for all of 2022, he had expected the yield on the 10-year note to rise to the 1.75%-2% range, “and three weeks in, we’re already smack-dab in that range.”
The questions now facing investors are how much of the rise in interest rates is in the rearview mirror and what are the risks that rates will jump again.
Answering starts with last-year's hot economic recovery, the supply-chain and labor market driven surge in inflation, and a sharp about-face at the Fed, where policy went from putting the pedal to the metal to keep the economy growing to hitting the brakes to choke off inflation before it becomes entrenched. The Fed is now expected to raise the federal-funds rate four times in 2022, beginning as soon as March. Just two months ago, expectations centered on two or three rate hikes for the year starting in May or June. (A plain-English guide to the Fed and how it works can be found here.)
Much will depend on the course of inflation and whether it stays stubbornly high or, as many analysts believe, it’s at its peak and will come down to more reasonable levels. The risk is that inflation won't fall fast enough or far enough from the December 7% year-over-year increase.
“It all comes down to inflation,” says John Briggs, global head of desk strategy at NatWest Markets.
Stubborn inflation would likely lead the Federal Reserve to act even more aggressively to push interest rates up than the markets are currently expecting, which would mean more tough sledding ahead for the bond market.
For investors, this means watching two key aspects of Fed policy. The first is what bond market pros call the terminal rate, which is the level at which the Fed eventually stops raising the funds rate. Currently that is seen as around 1.75%, up from zero today. Second is the timing of so-called quantitative tightening, where the Fed reduces the amount of reserves in the banking system; it is the reverse of the bond market purchases made to pump cash into the economy during the pandemic-sparked recession.
Schwab’s Martin says that while the firm believes the odds are in favor of bond yields not rising much further this year, “for us, it’s still too early to make an assessment, and a lot of it will take seeing what happens with the inflation outlook.”
Interest rates can be a tough market for many investors to wrap their arms around. There’s lots of jargon, and much depends on the obscure inner workings of the Fed. Underlying all this is the inverse relationship between bond prices and bond yields, and the idea that good news for the economy can be bad news for bonds.
To understand the sharp turn in the bond market means going back to the state of play in late 2021. Investors were increasingly convinced that the surge in inflation wasn’t as “transitory” as had been thought during the early Fall. At its December meeting, the Fed signaled it was shifting toward a tougher stance on fighting inflation, with expectations swinging solidly toward three rate increases in 2022.
However, in early January, when the Fed released the minutes from that December meeting, it turned out the Fed was considering being much more aggressive in raising rates and removing support from the economy than investors had realized. Expectations then shifted toward four rate increases this year.
“There was a sense of 'we might be behind the curve (on fighting inflation) if we don’t move faster,' and that was a surprise,” says NatWest’s Briggs. “They are going to get aggressive here.”
As expectations for higher rates from the Fed built, bond yields followed.
For now, Briggs says, “the market has priced in a fair amount from the Fed this year.”
Briggs says that from here, it will be critical to watch market expectations for where the Fed is expected to stop raising interest rates. For now, he says, interest-rate markets are expecting that the Fed will take the funds rate from zero to roughly 2% by the end 2023. While that likely means seven or eight rate increases, “that’s pretty low,” Briggs says.
Schwab’s Martin says to watch changes in those terminal rate expectations for clues on whether bond yields will move higher. Unless those expectations climb much beyond 2.25%, “we don’t see bonds going much higher in the Treasury 10-year yield.”
And those expectations, in turn, depend on the path for both inflation data and the pace at which it heads back down toward the Fed’s long-run target of 2%.
Morningstar's chief economist Preston Caldwell expects that inflation likely peaked in 2021 with its 7% rise, but will still remain elevated this year at 3.6%, in part because of extended supply chain snarls resulting from the omicron coronavirus variant.
It’s a similar outlook at Schwab, says Martin. “We have either seen the peak, or we think we are close,” he says. One factor working in favor of lower inflation rates is a purely mathematical one, where as this year goes on, the higher base of prices seen in 2021 will make it harder to see big percentage increases for 2022.
Briggs says he will be closely watching the Consumer Price Index reports for the February-April period. If inflation looks like it will settle in closer to 3%, he believes the market might need to reset for a higher terminal rate from the Fed and a higher-yield environment overall. That would mean a resumption of the bond market sell-off.
Until then, “we may have a period where the markets are just waiting to see if inflation will come down,” he says.
On the QT
The other important variable is the Fed’s plans for reducing the massive bond holdings it acquired since the start of the pandemic. These purchases, known as quantitative easing, pump money into the banking system and help keep market rates low. The Fed had already announced it will be slowing the pace of bond buying, aka tapering.
Now Fed officials are looking at when they will switch over to quantitative tightening, which is the opposite of quantitative easing. Expectations are building that this move could come in second half of the year. If inflation were to stay hotter than expected, that could accelerate the pace of QT. An unknown is how much of an impact QT will have on the bond market.
“Bond markets have been driven primarily through massive buying through the central banks,” says Morningstar’s Kemp. “How much of it is the buying really changing prices and how much of it is just the signaling from the central banks?”
Kemp notes that one of the dynamics in play has been a rise in what are known as real yields. These are yields that are adjusted for the impact of inflation. (Inflation erodes the value of the fixed-interest payments paid out by bonds.) Since the onset of the pandemic, real yields have actually been negative, meaning that investors have been willing to accept losing money after inflation is taken into account in exchange for the safety of owning bonds.
On the one hand, inflation expectations have been steady in recent months as the Fed has signaled a more aggressive policy stance. This can be seen in a measure known as the 10-year break-even rate, which is essentially the markets’ expectation for long-term inflation rates.
But much of the rise in yields this year can be tied back to a rise in real yields, which reflects investors demanding higher returns even after inflation has been taken into account, Kemp says. Real yields are still negative, but the direction trend appears to have changed.
For Kemp, is this is an important signal that ties back to the role Treasury bonds play in most investors' portfolios. With inflation higher than yields, investors are technically losing money on government bonds. Instead, those bonds play a role of diversifying the portfolio against the volatility of stocks. The idea is that when stocks fall sharply, bond prices will rise. “Why do you own bonds? Most of the time they provide crash protection for equities,” he says.
However, historically in a time of rising real rates, the insurance doesn’t work as well, he says. As evidence in recent weeks, both stocks and bonds have been posting declines. Rising real yields can also work against holdings of riskier bond categories, such as investment-grade corporate bonds or high-yield bonds, areas where more-attractive yield levels have drawn cash. “This is the real worry for investors,” Kemp says.