2022 was unambiguously bad for bonds.
You might say laughably bad, assuming you can find humor in the unfortunate. Through the end of last month, US Treasurys were annualizing a 23% loss, the worst since (and I’m not joking) the year after the Constitution was ratified.
That factoid comes from Global Financial Data, which builds indexes by appending historical records to more conventional series. Based on the same data, US government bonds have never suffered three straight years of losses. And so on. By now, everyone has seen those (and related) statistics.
Going forward, the situation is more nuanced. The most straightforward case for bonds is just that it can’t possibly get any worse. Then again, anything’s possible, so perhaps it’s better to say, as JPMorgan did this week, that “bond yields are unlikely to climb higher indefinitely.”
“This is not only because activity is slowing and our baseline has lower inflation/higher unemployment, but also because policy rates are expected to approach more extreme levels in the next few quarters,” analysts led by Marko Kolanovic wrote, adding that in the US, Fed funds is seen overshooting Taylor rule-implied levels based on expected inflation, and matching rule-prescribed levels based on realized inflation (figure on the left, below).
Plainly, that doesn’t mean we’ve seen “peak Fed.” We haven’t. As of Tuesday morning, terminal rate expectations were steady at around 5.10%. And, as JPMorgan went on to say, we haven’t necessarily seen “peak Fed hawkishness” either. A bevy of hawks, both traditional and born-again, will be on the record later this week.
The point, rather, is that if rates are expected to rise roughly to where they “should” be, and, I’d add, to levels that will likely constitute a positive real policy rate at some point in 2023 barring very bad luck on the inflation front, then, as Kolanovic and co. put it, it “gives more confidence that a lot of the move is already behind us.”
Additionally, note that after November’s hike, rates are restrictive. I realize that’s controversial in some corners, and I fully acknowledge that there’s something odd (farcical, even) about describing a policy rate that’s more than four full percentage points below headline CPI, as unequivocally restrictive. But these are very unusual circumstances. The Fed was hiking from the lower bound, and headline inflation took off to near double-digits from basically nothing. If the Fed had attempted to overtake headline CPI this year, they’d have needed to hike in 125bps increments at every meeting. I’m not aware of anyone, anywhere willing to suggest that was advisable.
“Historically, a real Fed funds rate exceeding trend real GDP growth hasn’t proved to be a durable equilibrium,” JPMorgan went on to say, on the way to suggesting that bond yields might “eventually follow their usual pattern around hiking cycles and start feeling gravity.” That’s a reference to the figure on the right (above). Again, if you look at where real Fed funds is likely to be mid-way through 2023, and consider the likely trajectory for real growth, it’s easier to make the case that policy is well on the way to being restrictive.
There’s nothing especially profound in any of this, of course. But it does, I think, underscore an increasingly important point which, despite being obvious, is nevertheless lost on too many market participants. The tension between rates, yields and inflation will almost surely resolve in some kind of “compromise,” wherein the glaring disparity between policy (Fed funds), markets (10-year yields) and the macro (CPI) closes from both ends.
That disparity is illustrated in the familiar scatterplot (above). The red squares are pandemic-era outcomes.
If this doesn’t resolve in a compromise, and all the work is left to policy and markets, then we’re all wasting our time.
Put differently, if Fed funds has to overtake a 40-year high inflation rate that refuses to fall (or keeps rising), or even if 10-year yields need to close the entire gap from the bottom up (so to speak), then strap in. Because it’s going to be a very bumpy ride.
I recommend everyone look at a story on page one of today’s WSJ: Covid Drag on Workforce Proves to Be Persistent.
Add this factor to the labor force shrinkage due to the drop in immigration and much is explained.
So we can thank GOP politicians who fought against Covid vaccinations/prevention measures along with supporting limits on immigration for the worker shortage. And now they are running on inflation which were partly responsible for. What a system ….
I guess I’m stating the obvious that the next few CPI reports will indicate how persistent inflation is. Who knows if this is the 70’s all over again but I think if it has to the Fed will go as high as needed. That’s their job. Nobody, with the possible exception of debt issuers, wants years of >5% inflation.
Yeah, but you have to understand: Market structure spent a dozen years optimizing around everyone’s favorite acronyms (i.e., ZIRP, NIRP and LSAP). Model parameters of all kinds are calibrated based on a decade of low volatility and forward guidance. If, by some stroke of very bad luck, inflation were to loiter near 9%, you could pretty easily argue that the Fed can’t go as high as needed. It’s not obvious that the system can handle that. Every day there’d be a multi-sigma event somewhere because the distribution was derived based on daily outcomes associated with the low vol regime. Nobody wants years of >5% inflation, but nobody wants rolling UK LDI-style blowups every week either. This is the big risk with stochastic inflation — if inflation doesn’t ever settle, I don’t think there’s going to be a lot central banks can do until markets have a chance to adjust to the new, wider distribution of daily outcomes. So, the hope is that inflation recedes enough to make 6% fed funds overkill. In other words, let’s say we get core down to ~5%. Then we can have 5.5%-5.75% fed funds, and say we’re at least in the ballpark. If core moves up even another half percent and sticks there, I don’t think there’s a lot anybody can do.
Government set I-bond interest rate for May- October, 2022 was 9.62%. The recently released rate for November, 2022 – April, 2023 is 6.89%. This is supposed to reflect CPI.
The “man behind the curtain” was a little high with 9.62%. Hopefully, a little high for the next 6 months, as well. Nonetheless, 6.89% is supposed to reflect the average over that 6 month period- so someone thinks actual CPI will be lower at the end of that 6 months.