How rising interest rates impact the bond market

December 1, 2022 | Market news

Key takeaways

  • 2022 was a year of dramatic change in the bond market as yields on the benchmark 10-year U.S. Treasury note reached their highest levels since 2010.
  • Yields retreated in November, but it’s not clear if this is a temporary rally.
  • An unusual “yield inversion” occurred, with 3-month Treasury bills paying a higher interest rate than 10-year Treasury notes.

2022 will be remembered as a year when bond investors were forced to adjust to a drastically different environment. While the benchmark 10-year U.S. Treasury note yielded just 1.5% at the end of 2021, reflecting a longstanding trend, things changed quickly in 2022. The yield on the 10-year Treasury rose throughout most of 2022, topping 4% in October, a level not reached since April 2010.1 Notably, the 10-year Treasury yield dropped below the 4% level again in November.

Rising bond prices are generally considered a negative development because of the inverse relationship between bond yields and bond prices. When yields rise, prices of bonds already in the market fall. This is a function of supply and demand. When demand for bonds declines, issuers of new bonds must offer higher yields to attract buyers, reducing the value of lower-yielding bonds already on the market. This environment hit bondholders hard through much of the year.

Interest rates tend to follow long-term growth and inflation trends. Higher inflation often results in higher interest rates. While interest rates held firm through 2021, a variety of developments altered the landscape in 2022. These include continued supply constraints for goods, a major shift in monetary policy by the Federal Reserve (the Fed) and Russia’s invasion of Ukraine.

Aggressive stimulus measures in 2020 and 2021, rising demand for goods and services, and supply chain disruptions contributed to a surge of inflation. The Consumer Price Index (CPI) reflected the changing landscape, rising by 9.1% for the 12-month period ending in June, its highest reading since 1981.2

“Bond yields rose primarily because the Fed pivoted to a much more hawkish position, as investors anticipated aggressive interest rate hikes to rein in inflation,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. Merz notes that bond markets tend to move in advance of specific Fed actions, often anticipating upcoming monetary policy moves.

The Fed’s influence on interest rate markets

The Fed uses interest rate hikes on the short-term federal funds rate it controls as a tool to dampen inflation. Higher interest rates are aimed at reducing loan demand and cooling the pace of economic activity. Fed Chairman Jerome Powell and other members of the policy-making Federal Open Market Committee (FOMC) made clear that the Fed’s “easy money” policies from 2020-21, which included maintaining a near 0% federal funds target rate (a short-term interest rate the Fed controls), had to change in response to the inflation threat.

From March through November 2022, the Fed aggressively raised the fed funds rate by 3.75%, a significant turn of events. This included four consecutive rate hikes of 0.75%. Powell, in a public statement in November 2022, indicated that “it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down.” While that may have been a signal of a less assertive Fed going forward, Powell also stated that, “Despite some promising developments, we have a long way to go in restoring price stability.”3 According to Merz, Powell is clearly looking for more convincing evidence that inflation has receded.

Another important strategy was the Fed’s reversal of its earlier quantitative easing program. As a feature of this strategy, the Fed was a major purchaser of U.S. Treasury and mortgage-backed securities. The Fed’s holdings totaled nearly $9 trillion. Since March, the Fed began to unwind this position by slowly reducing its holdings, a strategy referred to as quantitative tightening (QT). “The Fed is just getting started with this approach as another way to influence interest rates in the broader bond market,” says Rob Haworth, senior investment strategy director at U.S. Bank.

A flatter yield curve

Another trend is the unusual interest rate environment along the yield curve representing different bond maturities. Under normal circumstances, bonds with longer maturity dates yield more, dubbed an upward sloping yield curve. This state reflects a return premium for the greater uncertainty in lending money for a longer time. 2022 has been an unusual period where yields along the maturity spectrum have narrowed, reflecting a “flattening” of the yield curve.

U.S. Treasury Yield Curve Comparison
Dec. 31, 2021 and Nov. 30, 20221

In some cases, yields between different maturities inverted, meaning the yields paid on shorter-term securities are higher than those offered on longer-term maturities. Most notable is the inversion between 3-month and 10-year Treasury yields, which was modest at first, but deepened in November. A common view of many analysts is that such a yield curve inversion signals increased odds of a recession in the near future. “The deeper inversion lately may be a sign that the markets anticipate a more prolonged slowdown in the economy,” says Haworth. “For corporate borrowers, the cost of capital is going up more, making it less likely that any investment they make will see a payoff down the road.”

The Fed’s progress and ongoing hurdles

After year-over-year inflation peaked in June, slightly more favorable news emerged. By October, inflation over the previous 12-month period came in at 7.7%, its lowest level since the 12-month period ending in January 2022.2 This represents modest progress in the Fed’s efforts to combat rising living costs. “Decelerating year-over-year inflation is constructive,” says Merz, “but we need to see much more before the Fed changes its policy approach.”

Merz also notes that there’s a lag time between when the Fed puts interest rate policy into place and its impact on the broader economy. “Many economists believe the economic impact is felt 12-18 months after a change in interest rate policy, though some believe that lag is shorter,” says Merz. “We expect the Fed will continue increasing rates in the coming months, so recent and future rate hikes still may not flow through to dampen economic activity for some time.”

“Our emphasis is on high-quality investment-grade taxable and municipal bonds to manage overall risk exposure should interest rates continue to rise in the near term.”

- Bill Merz, head of capital markets research at U.S. Bank Wealth Management

Merz expects inflation to continue decelerating but remain elevated enough to keep pressure on the Fed to maintain high interest rates. He points out that there is a lag in when shelter costs appear in the inflation date, and that category makes up a significant portion of CPI. “Home prices rose considerably until recently, then dropped, and the recent change is still to be reflected in CPI. In the past few months, higher interest rates have led to decelerating home prices. That’s not yet incorporated in the CPI numbers,” notes Merz.

External events can also impact inflation trends. A prime example in the current environment is the Russian invasion of Ukraine. Russia is a major energy producer, particularly for Europe, while both countries are significant agricultural exporters. The conflict has affected the flow of oil, natural gas and food products. With supplies reduced, oil consumers push prices higher. “That’s outside the control of central banks,” says Merz. “Interest rate hikes by the Fed, the European Central Banks and others are meant to slow demand, but they don’t improve supply.”

Issues such as the war, the emergence of another overseas conflict or a resurgence of COVID-19 or other public health issues could contribute to an economic slowdown. “It’s more of a balancing act because of various events that can be disruptive to the economy,” says Haworth. “Along with watching inflation trends, the Fed will also keep an eye on whether consumer spending falters.” If there are further economic ramifications because of the conflict in Eastern Europe, the Fed’s monetary policy may have to adapt.

Does the Fed’s current policy mean that interest rates will continue trending higher as they have for most of 2022? Haworth says recent changes in bond yields, including a drop in 10-year Treasury rates, may indicate that bond investors are comfortable with where things stand. “While inflation is softening, there are still issues that may keep it elevated for a time,” says Haworth. “We see the Fed succeeding in helping to soften consumer demand and business spending, but supplies remain low for many goods and services, which can result in persistently higher prices.”

Yields on bonds in the broader market can also be affected by supply and demand issues. With the Fed dropping out as a buyer of Treasury bonds and mortgage-backed securities, other buyers have to step up. “The private market is now just starting to absorb the supply of Treasury securities that the Fed is no longer buying,” says Haworth. To this point, liquidity issues have been limited, but if that becomes a problem, it could drive interest rates higher. Haworth is watching the direction of the federal government’s budget deficit. “If deficits move lower, the market has plenty of capacity to absorb new bond offerings,” says Haworth. “But if deficits move higher, it may become more of a challenge.”

Finding opportunity in the bond market

As yields across the bond market trend higher, what are the best options for bond investors? The recent rise in interest rates means investors buying bonds now will receive higher yields. “We’re putting greater emphasis on core bond holdings,” says Merz. “We believe that bonds offer compelling defensive characteristics relative to stocks.” Specifically, he recommends both taxable bonds and, where appropriate, tax-exempt municipal bonds as reasonable positions for portfolios today. “Our emphasis is on high-quality investment-grade taxable and municipal bonds as well as a dedicated exposure to short-term U.S. Treasury investments to manage our overall risk exposure should interest rates continue to rise in the near term,” says Merz.

There is an important potential benefit for bond investors who concentrate more of their bond positions in high-quality segments of the fixed income market. “This is a way to add diversification to help manage risks in a portfolio that includes equities,” says Merz. While 2022 has so far proved to be a rare occasion where both stocks and bonds declined in value, Merz believes that over the long run, holding high-quality bonds will typically help smooth volatility in an investor’s diversified portfolio.

Bond investors still need to exercise caution, suggests Haworth. “Bonds offer better value today, but there are questions of how much higher interest rates may rise. It’s not clear how attractive the values are yet in long-term bonds,” says Haworth.

Additionally, investors may wish to consider other aspects of the fixed income market that offer unique potential. “We still see opportunities in strategies like insurance linked securities, also called reinsurance, which is uncorrelated to traditional stock and bond investments,” Says Merz. These are investments that provide financial backing of the risks taken by insurance companies. Merz notes that the yields offered on reinsurance products are very attractive in today’s environment. As an asset class, reinsurance tends to move differently from traditional assets as prices reflect weather and catastrophic events rather than economic developments. While losses may result in periods when costly events for insurers such as hurricanes occur, premiums collected by reinsurance companies typically offset such losses over time.

According to Merz, “This is a period when investors are likely to benefit from holding more high-quality assets and fewer volatile assets than in a typical period.”

Talk to your wealth professional for more information about how to position fixed income investments as part of a diversified portfolio.

 

Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities.

The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is generally free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes.

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