First Quarter Total Return Outlook
Published on January 5, 2023
2022 was a rough year for fixed income, but we anticipate better days ahead as the Fed will likely keep rates elevated in its ongoing battle against inflation.
Can I Have Another (Rate Hike)?
2022 saw the worst annual return for investment grade fixed income since the Bloomberg U.S. Aggregate Bond Index (Agg) began tracking in 1976. The fed funds rate was lifted by 425 basis points in just nine months. The last time we witnessed rate hikes of this magnitude was between 2004 and 2006, when Chairman Greenspan authorized seventeen consecutive 25 basis point hikes over two years. And yet, it seems that we are not quite done with this tightening cycle.
As fixed income investors, our focus for 2023 is singularly on the Fed’s battle against inflation and its impact on the markets. Although the central bank maintains its dual mandate of “price stability and maximum sustainable employment,” continued wage growth and tight labor markets should allow it to concentrate almost entirely on the problem of rising prices. It should be noted that the healthy labor conditions have contributed to inflation this year, suggesting (somewhat ironically) that the Fed has satisfied the employment portion of its mandate a little too well!
Required reading for 2023 is the transcript of the speech Chair Powell gave on November 30, 2022, titled “Inflation and the Labor Market.”1 He did a remarkable job breaking down the various drivers of inflation and addressed his expectation on how these drivers would evolve in the coming year. As the speech was not tied to a rate move or a Fed meeting it had more credibility as something of a reference tool rather than a form of market-moving policy suasion.
In this regard, we turn our attention to what we believe is the single most important data series to be tracked for 2023: the Underlying Inflation Gauge (UIG, Full Data Set), a time series we have referenced in past commentaries. It measures the persistent components of inflation, and it is as important now as ever. UIG peaked in March 2022 at 4.88% and has steadily declined to 4.14%. Unlike CPI, PCE, and other measures of inflation, UIG is relatively stable and exhibits significant inertia – which is intuitive since it focuses on the drivers of persistent inflation. It is reasonable to assume this index will continue to fall – with the primary question being when it will recede to something closer to 2%.
As for the fed funds target rate, we expect the Fed to remain vigilant and continue to hike rates at a newly decelerated pace. Their famous “dot plot” suggests a terminal rate above 5% and we see no reason to doubt this. Their steadfastness is evidenced by the cut-and-paste statements accompanying the last two rate hikes that revealed almost no change in language. Furthermore, the Fed has emphasized that it will maintain a relatively restrictive target rate for some time.
What does this mean for fixed income markets? We have witnessed two false starts in 2022 – one in the summer and the other in the fourth quarter, with investors getting ahead of the Fed in adding duration to portfolios and betting on an ease in 2023. If the Fed is taken at their word, we do not believe an ease is in the offing for 2023. For inflation to be contained, we believe restrictive policy needs to be implemented over a period of many months, or perhaps even years.
In our view, this means short rates appear too low – specifically 2-3 year maturities gearing for premature eases. We respect the inverted curve, and the more stubborn the Fed is with its 2% target, the further the curve can invert. This is driven by higher short-term rates (tracking with fed funds) while pricing in an increased probability of recession, depressing longer-term rates. We view short-term steepeners (i.e., brief selloffs) as opportunities to add duration in longer maturities, with the caveat that duration should be more aggressively added when it becomes clear the Fed is closer to done with this cycle, which may be several months away. If the pattern from the last three hiking cycles (late 1990s, mid-2000s, and mid-late 2010s) is repeated, the end of the cycle should be a terrific opportunity to add duration.
Drilling into sectors, we expect performance will be led by Treasuries. It has been 11 years since Treasuries have posted the best calendar year return among the three pillars of the Agg (agency mortgage-backed securities (MBS) and corporates are the other two) but, as the saying goes, perhaps “they’re due.” Restrictive policy generally creates underperformance among risk assets – be they equities, corporate bonds, or MBS – while Treasuries, as a safe haven, tend to perform better. But we also see a favorable scenario for corporates and agency MBS in 2023 if the Fed exercises some finesse with its policy and relaxes its intermediate inflation target to something higher than 2% – in effect tapping the brakes on the potential for a recession.
At this stage, we are focused on iteratively following economic data and monitoring the Fed’s response to that data. Inflation will be buoyed by elevated owners’ equivalent rent paradoxically related to increased mortgage rates, which have already stifled the housing market. The reshaping of the labor force, with decreased participation rates, will continue to provide upward pressure on wages. Nominal wages continuing to rise by over 5% per year will provide the primary challenge to the Fed’s inflation fight. By comparison, wages rose by about 1-2% annually before the pandemic. This should keep the Fed on track for raising rates beyond the market’s current comfort level, which puts us into a relatively defensive stance with regard to interest rate exposure in the first part of 2023. We expect to increase our duration exposure as the year goes on and the Fed completes its rate hikes. The steady decline in UIG suggests this should happen in the coming months.
1 “Inflation and the Labor Market,” Chair Jerome H. Powell, November 30, 2022, the Hutchins Center on Fiscal and Monetary Policy, Brookings Institution, Washington, D.C.
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The Bloomberg U.S. Aggregate Bond Index (Agg) is widely regarded as the standard for measuring U.S. investment grade bond market performance.
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The fed funds rate is the rate at which depository institutions (banks) lend their reserve balances to other banks on an overnight basis.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
Consumer Price Index (CPI) reflects the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
The PCE price index reflects changes in the prices of goods and services purchased by consumers in the United States.
The Underlying Inflation Gauge (UIG) captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.
A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
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