Stocks and bonds are both down considerably since the beginning of 2022 with the world equity market falling into “correction” again last week, off 10% from its peak. But relative to equities, it is the bond market that has been truly crushed. The value of 30-year US Treasury securities – the benchmark “long bond” – has fallen 18% year-to-date. Its cumulative total return has been -34% from its March-2020 peak.

The US Federal Reserve’s response to inflation is responsible for the violent speed of the bondholder’s reversal of fortune. The Fed has made one of its most abrupt “about faces” in history. Taken at its word, the Fed will begin “rapid” Quantitative Tightening roughly two months after halting Quantitative Easing. The central bank will go from encouraging fiscal expansion to reinforcing a fiscal contraction. Its projected short-term interest rate increases in the year ahead will roughly match the largest for any annual period in history.

• CIO believes the Fed is looking in the rear-view mirror. Growth in 2021 of 5.6% was fed by massive COVID stimulus. Unlike 2012-13, today’s economy is not overcoming a financial crisis, but is facing headwinds from a confluence of pandemic and war-related impacts, but most importantly, an “about face” in macroeconomic policy support.
• Higher bond yields naturally make sense in an inflationary period like this. But will today’s post-Covid, wartime circumstances be sustained for years? CIO thinks not – and already sees a material slowdown happening in the global economy.
• The absence of fiscal support this year amid high inflation is now forcing consumer demand to drop. Like Fed members, who have cut their median real economic growth view by 1.2 percentage points for 2022, CIO has cut its US growth forecast by a more severe 1.6 percentage points to 1.9% from 3.5%. Should the Fed raise rates too fast or remove liquidity too quickly, it may be the catalyst for the next recession.

Past performance is no guarantee of future results. Real results will vary.

Portfolio Considerations

• When bond yields were abysmally low, the value of bonds in portfolios was also low. Rates of 2.5%-3.0% on US government bonds in a period of slower global growth are starting to look far more interesting. And one can imagine rates going lower at some point in 2023.
• Will this happen again? CIO now believes US real GDP will be slightly below 2% in the first half of 2022 based on already moderating demand. If the Fed continues to tighten through the slowdown into 2023, the probability of a policy reversal will be high.
• The Fed may start to go down the path of higher rates and Quantitative Tightening (QT) only to realize that the economy is weaker than it thought and that inflation would head down its own accord over the next 12-18 months. After several perhaps large rate hikes and QT, the Fed may look toward a less robust future for labor markets and begin to moderate its policy path. In that case, we could also see peak rates. The CIO believes there is a 70% probability of peak rates in 2022 and that bonds could be a bright spot in the current environment – notably government bonds and high-quality corporates.