By Senior Advisor Kirk Ludwig, CFIP, AIF®.
The past year presented the financial markets with high volatility and change. Many of the imbalances caused by the pandemic continued to disrupt segments of the global economy and markets. From inflation soaring to a multi-decade high of 9% in June 2022, to lumber prices plummeting by nearly 65%, to global stocks trading in bear market territory for much of the year, volatility was widespread throughout financial markets.[1][2][3]
Given the complexity of the economic landscape, and the higher uncertainty that came with it, the volatility was not unusual from a historical perspective. However, one market that DID surprise many investors was the U.S. bond market. As one of the largest and most heavily traded financial markets in the world, the U.S. bond market was caught off guard as the Federal Reserve ramped up its campaign to battle inflation by aggressively raising short-term interest rates.[4]
The following chart puts perspective on the changes in Treasury rates across the yield curve. The one-year U.S. Treasury note started the year yielding 0.39% and ended with a yield of 4.73%. As illustrated, it wasn’t just short-term rates that were impacted - rates for all other maturities across the yield curve rose as well.
Source: “Daily Treasury Par Yield Curve Rates“. U.S. Department of the Treasury, treasury.gov.
It's not uncommon for the Federal Reserve to raise or lower interest rates to control economic growth and inflation. However, in this case, the surprise was the speed and magnitude of the rate hikes. With the starting point of short-term interest rates near 0%, bonds didn’t stand much of a chance to generate enough income to offset the change in prices associated with the rapid increase in yields. As a result, the general U.S. bond market suffered one of its worst years in recorded history.[5]
There is a silver lining to higher yields! Over the past decade, conservative investors holding short-term bonds, CDs, money market vehicles, or cash in checking & savings accounts have suffered historically low returns.[6] Now, the spike in interest rates is providing yields on conservative ultra-short-term investments such as one-month Treasury bills at 4% or better. Those willing to extend Treasury maturities to a year can expect to see yields north of 4.5%.
As the Federal Reserve continues its mission of driving inflationary pressures lower, while attempting to avoid a recession, the Fed may continue to raise interest rates further in the near future. We believe further interest rate increases are less concerning compared to a year ago because the risk and return tradeoffs are more favorable for bond investors today.
At SJS, we are consistently monitoring all segments of the markets and assessing the risk and return characteristics of each asset class. For 2022, the bond asset class started the year with extremely low yields and less desirable return expectations. Going into 2023, the higher yields provide bond investors with a brighter outlook!
Important Disclosure Information & Sources:
[1] “Consumer Price Index for All Urban Consumers: All Items in U.S. City Average“. Federal Reserve Bank of St. Louis, fred.stlouisfed.org.
[2] “Lumber (LBS)". Nasdaq, nasdaq.com.
[3] “SJS Weekly Market Update“. SJS Investment Services, 2022, sjsinvest.com.
[4] “Money, Banking, & Finance“. Federal Reserve Bank of St. Louis, fred.stlouisfed.org.
[5] The general U.S. bond market is represented by the Bloomberg U.S. Aggregate Bond Index, which measures the performance of investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. Data source: Morningstar, 1976-2022.
[6] “Interest Rates“. Federal Reserve Bank of St. Louis, fred.stlouisfed.org.
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Statements contained in this article that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
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