Key takeaways

  • Bond yields ae significantly higher today than has been the case in recent years.

  • The benchmark 10-year Treasury bond yield recently topped 4% for the first time since 2010.

  • An unusual “yield inversion” remains in place, with 3-month Treasury bills paying a higher interest rate than 10-year Treasury notes.

Investors continue recalibrating to account for unusual bond market dynamics. Take the benchmark 10-year U.S. Treasury note, which yielded just 1.5% at the end of 2021, reflecting a longstanding trend of lower interest rates. The yield then rose dramatically in 2022, peaking at more than 4% in October, a level not reached since April 2010. It’s leveled off since cthen, but remains elevated.

Rising bond yields are a negative for bond holders because of the inverse relationship between bond yields and bond prices. When yields rise, prices of current bond issues 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 in 2022.

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 included continued supply constraints for goods, a major shift in monetary policy by the Federal Reserve (the Fed) and Russia’s invasion of Ukraine.

The result was an inflation surge from early 2021 through mid-2022. The Consumer Price Index (CPI) peaked at a level of 9.1% for the 12-month period ending in June, its highest reading since 1981.

“Bond yields rose in 2022 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 raise borrowing costs to slow economic activity and dampen inflation. 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.

The Fed pursued an aggressive interest rate policy, and by December 2022 had raised the fed funds rate by 4.25%, a significant turn of events. Powell indicated that the Fed may become less assertive going forward, but 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 of a sustainable inflation slowdown.

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 2022, the Fed began to unwind this position by slowly reducing its holdings, a strategy referred to as quantitative tightening (QT). “The Fed sees this as another way to influence interest rates in the broader bond market,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management.

 

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. It logically reflects the thinking that investors should earn a return premium for the greater uncertainty inherent in lending money over a longer time period. The current environment is unusual, as yields along the maturity spectrum have narrowed, reflecting a “flattening” of the yield curve.

 

U.S. Treasury Yield Curve Comparison
Dec. 31, 2021 and Jan. 30, 20231

Graph depicts a normal yield curve at the end of 2021 (represented by the blue line) as compared to the inverted yield curve (represented by the red line) that exists at the end of January 2023. The graph plots the relative yields 3-month, 2-year, 5-year, 10-year and 30-year U.S. Treasury securities.

The curve is nearly downward sloping today, compared to the normal upward sloping curve. Most notable is the inversion between 3-month and 10-year Treasury yields, which become more pronounced at the end of 2022 and in early 2023. 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, increasing the required rate of return for successful projects or investments.”

 

The Fed’s progress and ongoing hurdles

After year-over-year inflation peaked in June 2022, slightly more favorable news emerged. By December 2022, inflation over the previous 12-month period dropped to 6.5%, its lowest level since the 12-month period ending in October 2021.2 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.”

“Our emphasis is on high-quality investment-grade taxable and municipal bonds to manage overall portfolio risk exposure should the economy continue to slow.”

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

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. He expects inflation to continue decelerating but remain sufficiently elevated that it results in pressure for the Fed to maintain high interest rates.

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, ongoing supply constraints, or a resurgence of COVID-19 cases, for instance, could exacerbate 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 must keep an eye on whether consumer spending falters.”

Does the Fed’s current policy mean that interest rates will continue trending higher as they have for most of 2022? Haworth says a lot hinges on the path of the economy. He warns, “there’s no ‘all clear’ sign as to what’s next. If the economy avoids a recession and growth resumes at a faster pace, it could push long-term interest rates higher. If the economy slows from here, longer-term yields could drop.”

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 and foreign buyers must absorb the supply of Treasury securities the Fed is no longer buying,” says Haworth. To this point, there are limited liquidity issues in the U.S. Treasury market, 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 likely has 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 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 a rarity occurred in 2022 as 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. “At current levels, bonds appear closer to what would be considered fair value.” Yet Haworth believes short-term bonds may offer more protection for bond investors given the current uncertainty about the direction of interest rates.

Additionally, investors may wish to consider other aspects of the fixed income market that offer unique potential. Government-sponsored mortgage-backed securities represent an opportunity to earn competitive income while being well positioned from a pricing perspective. Given the recent slowdown in housing market activity, there is a favorable supply-demand balance in the mortgage-backed market. There is also an opportunity with mortgage-backed securities that are not government-issued, as they offer the potential to boost returns.

According to Merz, “This remains a time 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.

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Disclosures

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  1. U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates.

  2. Source: U.S. Bureau of Labor Statistics.

  3. Cox, Jeff, “Fed Chair Powell says smaller interest rate hikes could start in December,” CNBC.com, Nov. 30, 2022.

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