Morning Market Commentary:
- Bond prices and yields have an inverse relationship.
- Federal Reserve interest-rate hikes have kept bond prices stagnant
- The central bank's biggest hawk recently signaled the rate-hike cycle is close to ending.
The bond market is poised for steady gains this year...
Since the second half of 2021, one topic has been front and center for every investor... inflation! After all, Congress and the Federal Reserve unleashed more than $10 trillion worth of stimulus on the U.S. economy on the heels of the COVID-19-driven financial collapse.
They were trying to stave off another economic depression like we saw in the 1930s. But, like any other time, the government meddles with the economy or industry, something gets broken. And this time was no different!
Individuals flush with money spent it on everything. Demand outstripped the available supply. So, producers charged more because their costs were rising and they saw the opportunity to make more money. The net effect of this was runaway inflation. Take a look at the following chart of the prices received by manufacturers for goods compared with the U.S. Bureau of Labor Statistics' Consumer Price Index ("CPI")...
So, the Fed had little choice but to raise interest rates. The idea was to kill economic demand and increase the value of the dollar. That way, supply chains could rebuild inventories and prices could stabilize. That would help bring costs back under control. As a result, the federal funds rate rose faster than it has since 1980, going from 0% to 4.5% in 2022.
That's a problem for bonds. You see, fixed-income prices and interest rates have an inverse relationship... When yields are rising, prices fall, and vice versa. So, if you're a bondholder, or thinking about buying them, you don't want to invest when you think rates will rise rapidly. Your best bet is to wait it out and get in when you think the rate-hike cycle has ended.
And based on recent commentary from a key central bank policymaker, the end could be quickly approaching...
As COVID-19 allowed individuals and households to work remotely, they didn't need to spend as much on things like traveling to work or dining out. That resulted in them having more money to spend. To see what I mean, take a look at the following chart of the U.S. personal savings rate as a percent of disposable income...
We can see that at the start of the pandemic in 2020, households had record levels of disposable money. So, the introduction of even more stimulus in 2021 meant the party kept on going. The result was super-charged demand for all types of goods. Supply chains were overwhelmed, and prices shot up as a result.
Last year, as rates went up in response, bondholders got destroyed. Take a look at the following chart showing the performance of the iShares 20+ Year Treasury Bond Fund (TLT), the iShares 7-10 Year Treasury Bond Fund (IEF), and the iShares 1-3 Year Treasury Bond Fund (SHY) to see what I'm referring to...
Debt investors either dumped some of their holdings or abstained from the market altogether. They decided the best bet was getting in at a later date when the central bank stops raising rates. That way, they can capture better returns from both an income and capital perspective.
On a total return basis (dividends reinvested), TLT lost 31.2%, IEF dropped 15.2%, and SHY fell 3.9%. Those are noteworthy changes compared with their long-term averages. Over the last 20 years, TLT has gained 4.4% per year, IEF has increased 3.5%, and SHY has added 1.6%. In other words, the underperformance of these assets was anything but normal.
But that poor performance means they're set up for a snapback rally and that opportunity lies ahead...
Over the past few years, Federal Reserve Bank of St. Louis President James Bullard has been the most prescient of all the central bank policymakers. He called for loosening policy ahead of the COVID-19 pandemic and began demanding rate hikes in the summer of 2021.
Last year, Bullard was the most hawkish (inclined to raise interest rates) of any member of the rate-setting Federal Open Market Committee. In the fall, he stated rates may need to go as high as 7%. But that has recently changed.
Last week, the St. Louis Fed chief said interest rates may finally be reaching a level that should restrict inflation growth. He said raising the federal-funds target to the 5% to 5.25% level should give the central bank room to stop increasing and study the economic fallout. In fact, he said at that level, the tight labor market should be enough to stop output from experiencing any serious declines.
If you're a bond investor, or intend to be, that's great news...
Given Bullard's past foresight, it's a signal the uncertainty of how high interest rates will rise is behind us. That means anyone wanting to invest in 10-year U.S. Treasurys can lock in a yield of around 3.5%, a much better rate than 2020's 0.5% or the S&P 500 Index's 1.7%.
So, as money managers get a better sense that the rate-hike cycle is coming to an end, don't be surprised when they grow more optimistic about fixed-income assets. As they start chasing those attractive yields, demand will overwhelm available supply. Eventually, that will drive the underlying value of those bonds higher.
So, the situation should now provide investors with the opportunity to attain a steady income stream with plenty of upside potential.