The usually sedate bond market has been unsettled by worries about inflation, the Federal Reserve’s interest rate increases and even the possibility of a recession.
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The stock market usually gets the headlines while its bigger cousin, the bond market, customarily plays a more sedate role, quietly generating steady returns with little fanfare.
But that has changed lately, and in a painful way for investors.
Hammered by high inflation and the start of interest rate increases by the Federal Reserve and other central banks, the bond market is having a horrendous year — producing painful losses on a scale last seen in the 1980s.
“It’s been decades since we’ve seen wholesale declines like these,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. Ms. Jones has been predicting that bond prices would fall and yields would rise for several years, though she did not anticipate a shift as abrupt as this one. “It’s a shock for people if they weren’t already expecting it.”
Although the global bond market dwarfs the stock market, measuring the declines in bonds in an easily understandable way is tricky, partly because no bond index possesses the name recognition of the Dow Jones industrial average or the S&P 500 stock index.
One benchmark for the investment-grade U.S. bond market has been called the Bloomberg Aggregate Bond index since August. (Those who have followed bonds closely through the years may recognize it “under the banner of Kuhn Loeb, Lehman Brothers, Barclays or Bloomberg Barclays,” Bloomberg noted when it rebranded the index.)
Whatever you call it, this venerable bond index, which is mirrored by many exchange-traded funds and index funds, was down 6.2 percent this year. That puts it on a course for its worst quarterly performance since 1980, according to Bespoke Investment Group.
These poor returns aren’t limited to the U.S. bond market. They are global in scope, as are their causes — roaring inflation worsened by rising oil prices in the wake of Russia’s invasion of Ukraine, and the efforts of central banks to contain inflation.
The Bloomberg Global Aggregate index, a comparable measure of global bonds, was down 6.6 percent so far this year and off 11 percent from a high in January, one of the worst drawdowns since that index’s inception in 1990, according to Bloomberg.
These miserable performances don’t quite amount to a role reversal with the stock market, however, because stocks have had more than their share of attention-grabbing gyrations this year, too.
At one point this month, for instance, the S&P 500 had fallen more than 10 percent, into the range known in market jargon as a correction, and the Nasdaq composite index was down more than 20 percent, into what Wall Street labels bear market territory, though both have since rallied. Still, the S&P 500 on Friday was down 4.7 percent for 2022, and the Nasdaq has declined more than 9 percent.
The historically bad bond returns are nothing compared with the periodic collapses of the stock market. For example, in February and March 2020, the early days of the coronavirus pandemic, the S&P 500 fell nearly 33 percent in just 23 trading days. Nonetheless, the double whammy of bad bond returns combined with poor stock market returns in the same stretch leaves many diversified stock and bond portfolios in a state of distress.
The Vanguard Balanced index fund, a plain vanilla mixture of 60 percent stock and 40 percent bonds, is down 5.8 percent for the year. Bonds, which generally serve as a buffer that insulates investors from the volatility in their stock holdings, have not performed that function well this year.
The culprit for the sharp decline in bond values is the rise in interest rates that accelerated throughout fixed-income markets in 2022, as inflation took off. Bond yields (a.k.a. interest rates) and prices move in opposite directions.
The interest rate rise has been expected by bond market mavens for years. It’s the suddenness of recent increases that has caused a ruction in the Steady Eddie bond market.
Consider that in August 2020, in the first year of the pandemic, the yield on the benchmark 10-year Treasury note fell as low as 0.5 percent. The Federal Reserve, which has direct control of the short-term federal funds rate — but not of bond market rates — had lowered that short-term rate near zero, much as it had done in 2008, during the financial crisis.
In both cases, the Fed and the U.S. government, through fiscal stimulus, were making extraordinary efforts to revive the economy: Low interest rates encourage borrowing and business activity, just as higher rates discourage it.
From a longer vantage, the August 2020 trough may just possibly have marked the end of a 40-year bull market in bonds. The rock-bottom 10-year yield that summer was the culmination of a decline from a peak of more than 15.8 percent in 1981. That peak occurred, not coincidentally, when Paul Volcker was the chairman of the Fed and the Consumer Price Index was rising at a 14.8 percent rate. After Mr. Volcker vanquished inflation, interest rates began their long descent. Now, along with inflation, they are rising, and that shift is hurting the price of a broad array of bonds.
The 10-year Treasury’s current level, nearly 2.5 percent, represents an enormous increase in yield since that nadir — and a nasty decline in bond prices — made all the more painful because much of it has occurred since the start of this calendar year, when the 10-year yield was just 1.51 percent.
Rising concerns. Russia’s invasion on Ukraine has had a ripple effect across the globe, adding to the stock market’s woes and spooking investors. The conflict has already caused dizzying spikes in energy prices, and could severely affect various countries and industries.
The cost of energy. Oil prices already were the highest since 2014, and they have continued to rise since the invasion. Russia is the third-largest producer of oil, so more price increases are inevitable.
Gas supplies. Europe gets nearly 40 percent of its natural gas from Russia, and it is likely to be walloped with higher heating bills. Natural gas reserves are running low, and European leaders worry that Moscow could cut flows in response to the region’s support of Ukraine.
Food prices. Russia is the world’s largest supplier of wheat; together, it and Ukraine account for nearly a quarter of total global exports. Countries like Egypt, which relies heavily on Russian wheat imports, are already looking for alternative suppliers.
Shortages of essential metals. The price of palladium, used in automotive exhaust systems and mobile phones, has been soaring amid fears that Russia, the world’s largest exporter of the metal, could be cut off from global markets. The price of nickel, another key Russian export, has also been rising.
Financial turmoil. Global banks are bracing for the effects of sanctions intended to restrict Russia’s access to foreign capital and limit its ability to process payments in dollars, euros and other currencies crucial for trade. Banks are also on alert for retaliatory cyberattacks by Russia.
What has happened since then? Briefly put, the Consumer Price Index reached a 7.9 percent annual rate, the unemployment rate dropped to 3.8 percent, and Russia invaded Ukraine, sending the prices of oil and other critically important commodities soaring. Faced with all this, at its last policymaking meeting, the Federal Reserve Open Market Committee began raising the federal funds rate and said it would keep doing so. Jerome H. Powell, the Fed chairman, has vowed with increasing urgency to do whatever it takes to bring inflation down to more modest levels.
The sharp rise in bond rates has produced some dislocations along the way, sending out signals that have, in the past, sometimes meant that a recession was on the horizon. They are worth monitoring closely, but the picture they give now is murky, at best.
First, some background: Bond rates are set by traders in the market, not by the Fed. Typically, when the economy is growing, investors receive a premium for lending money for longer periods. But sometimes short-term interest rates go higher than long-term rates.
When that happens, the bond market calls it a “yield curve inversion” and it implies, at the very least, that financial conditions are becoming tighter — and, possibly, that economic activity will slow so much that a recession is in the offing.
In the last few weeks, there have already been inversions of the yield curve, and more are likely. But what does it mean?
Undoubtedly, the Russian invasion and the oil price shock it has caused raise the risks to the economy. And just this week, the Federal Reserve Bank of Dallas warned that “if the bulk of Russian energy exports is off the market for the remainder of 2022, a global economic downturn seems unavoidable.” But the war in Ukraine and Western sanctions on Russia have uncertain outcomes. And a recession is possible but not yet clearly predicted by the bond market.
Instead, Joseph Kalish, chief global macro strategist for Ned Davis Research, an independent financial markets research firm, said the “nominal” yield curve inversions are “telling us an inflation story, not a recession story.” They suggest that markets have concluded that while inflation is spiking now, it may not last.
Furthermore, he pointed out that the “real yield curve” — for securities that are adjusted for inflation — gives a very different picture. It suggests that the economy is growing rapidly, that short-term interest rates still need to rise much further — and that no recession is on the horizon. “We’re just in a very uncertain period,” he said.
Getting through that uncertain period may require patience. In that regard, long-term bond investors may have a big advantage, because bond losses don’t dominate the news cycle the way declines in the stock market do. Sometimes, staying away from the day-to-day news is the best thing you can do.
Bond Market Unsettled by Inflation Worries – The New York Times