Fixed Income Outlook: Bonds Are Back

It has been a long time coming, but 2023 looks to be the year that bonds will be back in fashion with investors. After years of low yields followed by a brutal drop in prices during 2022, returns in the fixed income markets appear poised to rebound. It's likely to be a bumpy ride due to the cross currents created by global central banks' tightening policies, a volatile global economy, and ongoing political uncertainty here and abroad. Despite these challenges, we see opportunities in 2023 for the bond market to provide investors with attractive yields at lower risk than we've seen for several years.

We look for the Federal Reserve to end its rate hikes in early-to-mid 2023 amid a soft, perhaps recessionary, economy that brings inflation lower. The yield curve is likely to remain deeply inverted as monetary policy remains tight. Assuming the Fed sticks to its tight policy stance at the expense of economic growth, ten-year yields could fall as low as 3%. With that backdrop, we favor adding duration to bond portfolios during periods of rising rates, while staying up in credit quality.

In 2022 the bond market went through a huge resetting of interest rates. Coming into the year, short-term interest rates were still near the pandemic-era low of close to zero. The Federal Reserve began a gradual shift to tighter monetary policy with a 25-basis-point rate hike in March 2022 as economic growth recovered. Gradualism soon gave way to rapid tightening by summer as inflation surged on the back of supply/demand imbalances, a resilient economy, and the spike in oil prices due to the war in Ukraine.

In all, the pace of rate hikes has been the most rapid in modern times.

With starting yields low and the rate of change in tightening so fast, nearly every segment of the fixed income markets experienced declines, especially bonds with long durations. In fact, performance in 2022 year to date has been  an anomaly. Even in past periods of sharply rising interest rates, bonds have usually delivered positive returns since the income from a bond's coupon offset price declines. However, during 2022, without the cushion of high coupon income, returns were historically weak.

Our optimism about returns for 2023 is based on three factors:

• Starting yields are the highest in years—in both nominal and real terms;
• The bulk of the Fed tightening cycle is over; and
• Inflation is likely to decline.

After a long drought, the bond market is awash in yields that are attractive relative to other income investments. A portfolio of high-quality bonds—such as Treasuries and other government-backed bonds, and investment-grade corporate bonds—can yield in the vicinity of 4% to 5% without excessively high duration. Tax-adjusted yields in municipal bonds are also attractive for investors in higher tax brackets. In addition to the relatively attractive yields, higher coupons for newly issued bonds should help dampen volatility.

Yields have not only moved up in nominal terms, but in real terms as well. (Real yields are nominal yields adjusted for inflation expectations.) Two-year Treasury real yields now exceed the 2019 peak level, while five- and 10-year real yields are at the highest levels since 2009. High real yields in risk-free Treasuries mean investors don't have to look to riskier segments of the market for returns that will beat inflation. Moreover, by raising the cost of capital to businesses and households, high real yields tend to slow economic growth.

Comments from Fed officials signal that they plan to keep hiking rates in early 2023, albeit in smaller increments than this year. Now that the federal funds rate is approaching a level considered restrictive—high enough to slow growth and inflation—it will likely reduce the size of rate hikes. The market is discounting a 50-basis-point rate hike at the December meeting and then two 25-basis-point rate hikes at the following meetings in the first quarter, bringing the target range for the fed funds rate to 4.75% to nearly 5%. That seems reasonable to us.

Note that the market is discounting the likelihood of rate cuts by the end of 2023, but Fed officials are indicating that they plan to hold rates high for "a while longer" until they are confident that inflation is heading to the 2% target. That difference—between what the market is pricing in and what the Fed is signaling—is the key to the direction of yields for much of the year. If the Fed holds the federal funds rate near 5% or above all year, then it's likely that longer-term yields will experience bouts of volatility with 10-year Treasury yields potentially retesting the 2022 highs in the 4.25% to 4.5% region.

However, we lean toward the market view that by late 2023, the Fed will likely be cutting rates. By mid-year, the aggressive rate hikes to date should result in weaker economic growth and falling inflation, pulling long-term yields lower. Historically it has taken six to 18 months for the impact of higher interest rates to show up in economic data. Given the "front loading" of rate hikes since March, the economy is only beginning to feel the impact of tightening.

Wholesale goods prices have been falling sharply over the past year. On a year-over-year basis, producer prices for crude goods have dropped by 5%, while intermediate and finished goods prices are also starting to soften. This "disinflation in the pipeline" will likely work its way through the economy, pulling overall inflation lower.

The steep inversion of the yield curve (that is, the difference between short-term and longer-term yields), which has historically been a reliable signal of recession in a year's time, also suggests that credit availability is tightening which generally leads to slower growth.

Moreover, this has been a synchronized global tightening cycle, led by the Federal Reserve. A wide range of central banks throughout the developed and emerging world have been hiking rates to fight inflation and support their currencies. Consequently, excluding the COVID-19 crises, global gross domestic product (GDP) growth is running at its slowest pace since 2009 and the dollar recently hit a 20-year high. A strong dollar tends to dampen inflation by reducing the cost of imports and slowing exports.

Finally, the Fed has also ramped up its quantitative tightening program—the process of allowing its balance sheet to shrink by up to $95 billion per month. The aim is to reduce it by about $2.5 to $3 trillion over the next few years, bringing it down to pre-pandemic levels relative to GDP. Quantitative tightening is designed to work through several different channels. The most powerful, in our view, is that it signals that money is getting tighter. When combined with higher interest rates, the signal leads investors to reduce risk.

The key to the direction of Fed policy, however, is in the labor market. Fed Chair Jerome Powell has made it clear that the Fed wants to see a "looser" labor market with slower growth in wages, as the Fed is worried that rising wages will lead to persistently high inflation. The rebalancing of the labor market has lagged in rebalancing compared to other areas of the economy. The supply of workers has been held back by a variety of factors, including COVID-related health issues as well as lack of immigration while demand has stayed firm. Consequently, as the economy rebounded from the pandemic, wages reset higher in the last year to draw more workers back into the labor force.

Looking into 2023, we expect the pressure on wages to ease. Wage growth already appears to have peaked and is starting to decline. Average hourly earnings have slowed to a 5.1% year-over-year pace from 5.6% in March. As economic growth slows, wage growth will likely continue to retreat. Our guess is that the Fed would like to see wage growth in the 2% to 3%  region—where it was before the last tightening cycle began.

Fed officials have repeatedly referenced the policy mistakes of the 1970s as a reason to keep interest rates high even after inflation has started to fall. They want to avoid easing too early because it might allow inflation to rebound and inflation expectations to become embedded, leading to a wage-price spiral. We don't believe that the current period is a repeat of the 1970s, but since that's the Fed's view, we have to take it into consideration in making a forecast for Fed policy.

To date, inflation expectations have remained low considering the high level of current inflation. Market-based measures such as the yield spread between Treasury Inflation Protected Securities (TIPS) and nominal Treasuries show expectations of about 2.5%, while survey-based readings show long-run inflation expectations near 3%. Both measures have declined since the Fed started hiking rates—a sign that the market believes the Fed will succeed in holding down inflation long-term.

On the flip side, the Fed also focuses on financial stability.

In our view, the conditions that would warrant a rate cut by the end of 2023—recession, declining inflation, and slower wage growth—are the most likely scenario. Consequently, our expectation is that a rate cut near the end of 2023 is likely.

The major risk to our view would be a resurgence in inflation. It could materialize from a more-rapid-than-expected reopening of China's economy from its COVID lockdown policies, a spike in wholesale goods prices due to the Russia-Ukraine war, a stronger-than-expected pace of consumer spending domestically, or a sharply weaker dollar. These are factors we are watching but given the amount of global tightening in monetary policies year to date, the risks appear skewed to slower growth and inflation.

We are optimistic about returns in the fixed income markets in the year ahead. Yields are starting at the highest levels in years, and the bulk of the rate hikes for this cycle appear to be behind us. Economic growth is slowing, and inflation is abating in response to the rapid pace of tightening by central banks, allowing room for long-term yields to fall.

Ten-year Treasury yields could rebound toward the 4% level at times if inflation surprises hit, but by year end yields should be closer to 3% to 3.25%. That spells the opportunity to invest for income and potential capital gains. We suggest investors continue to increase duration, keeping the average near an investor's long-term benchmark.

We are cautious about taking too much credit risk in the face of slowing economic growth or recession. Current yields on riskier bonds, such as high-yield bonds, don't provide extra compensation for the extra risk, in our view. That may change as the year progresses, but for now we are neutral.

Volatility is likely to remain elevated as markets transition from a zero-interest-rate world to one with high real rates and heightened geopolitical risks. But our message is one of optimism for bond investors.