Fixed Income Commentary – February 2022

Slippery Conditions Ahead


Bond yields rose in January to start the year off in similar fashion to 2020. A year ago, the bond market was reacting to the imminent rollout of vaccines which seemed to offer hope for an end to the pandemic. This year, even as the pandemic continues to rage, the bond market is contending with a pivot in Fed policy. By the end of March, monthly purchases of Treasuries and MBS will end, the first rate hike is expected to occur, and the beginning of balance sheet runoff will likely be a matter of months away. While much of this has been communicated through various means, the tone has turned more hawkish (translation: aggressive) than previously assumed by many market participants, sending yields higher (45 basis points higher on the two-year Treasury, 27 on the ten-year). As a result of all this, total return performance for the month as represented by the Bloomberg U.S. Intermediate Aggregate Index was -1.25%. Even the Bloomberg Municipal Bond Index had a tough month with a total return of -2.74%.

Ever since the onset of the pandemic in early 2020, bond yields have been unusually low due to the unprecedented nature of the economic shutdown, the myriad risks to the economy, and the general uncertainty emanating from this worldwide issue. Now, with the Fed getting ready to begin returning monetary policy to a more neutral stance (albeit gradually), bond yields are climbing. We all know that bond prices move inversely to interest rates, so prices on outstanding bonds are generally declining. The rate of decline differs depending on many factors, such as the maturity of the bond, but the trend toward higher yields will likely persist based on what we know right now, although certain sectors and points along the maturity curve may fare better than others. The Fed’s confidence in the economic outlook is a positive sign, indicating that higher interest rates are now appropriate given the underlying strength of the economy. It is also encouraging that Fed officials appear determined to maintain their inflation-fighting credentials that were won over decades.

As yields rise and prices fall on existing holdings, we have a simple message: do not panic. Investing in bonds is primarily for the income and capital preservation features they offer. When bond yields move higher, cash flows from existing holdings can be reinvested at higher yields, thus improving the returns from those bonds. We advise being patient since, assuming the bond is held to maturity, there should be no realized loss, and reinvestment at higher prevailing yields can be advantageous to the ultimate earnings from the investment.


Moving on to other developments in January, credit spreads (the compensation investors receive when investing in bonds with credit risk, or non-government bonds) widened a bit in sympathy with the “risk off” move in equities. As noted above, municipal bond valuation metrics also turned south. Both developments make future purchases that much more attractive for investors.

As for economic reports, much of the data continues to be distorted by the Omicron wave which has caused many to be absent from work, school, and daily activities. With that caveat, there were a few noteworthy reports worth mentioning:

  • Population growth in the U.S. amounted to just 0.1% in 2021, the slowest on record dating back to 1900 (based on data from 7/20 to 7/21). We continue to view this worrisome trend as a negative risk factor for future economic growth.
  • The labor market reports for December were a mixed bag: the establishment survey showed a gain of only 199K jobs, but the household survey showed a much larger gain of 651K. These reports were likely distorted by the ongoing pandemic and the Omicron variant.
  • The economy grew at a 6.9% annualized rate in the fourth quarter, while full year growth came in at 5.7%. It is widely understood that such a pace is well above the economy’s potential growth rate, which itself is a function of labor force growth, productivity growth, and capital expenditure spending. That is one reason for the sudden emergence of inflation, on top of the fact that supply chain disruptions are rampant and the demand for goods has far exceeded recent trends. Growth in inventories accounted for 4.9 percentage points of the fourth quarter GDP growth rate, and real private inventories remain 2.7% below pre-pandemic levels according to Wells Fargo, which suggests that further inventory growth is likely. How inventory levels are managed over the next few years as a result of the pandemic and the ongoing supply chain crisis remain open questions and it certainly seems like a topic that will reappear frequently.

 

 

The Omicron variant has surely wreaked havoc on the economy by increasing the rate of absenteeism for all kinds of workers. On top of that, heightened geopolitical risk over Ukraine is likely contributing to a growing sense of unease, particularly in energy and commodities markets. And even with the Fed’s more transparent communication policy compared to decades ago, the upcoming quantitative tightening era is only the second such event in recent times, and the U.S. is not alone. The Economist reports that nearly $12 trillion of quantitative easing (bond-buying) was conducted by global central banks during the pandemic, so there’s a much bigger reduction that must occur over time. All of this explains why markets have become so jittery in such a short span.

In closing, a stormy weather forecast appears an apt metaphor for financial markets, but opportunities are likely to emerge for those who are prepared, vigilant, and forward-looking.