4th Quarter 2022 Fixed Income Review
• Although most fixed income sectors had negative performance for the year, select sectors had positive performance in Q4
• The Fed raised rates seven times in 2022, pushing its benchmark from a range of 0% to 0.25% early in the year to the current 4.25% to 4.50%, a 15-year high
• Fed officials signaled in December that they plan to keep raising rates to between 5% and 5.5% in 2023
• Although some economic readings have trended lower in recent months, the core rate of inflation remains elevated and much higher than the Federal Reserve’s target near 2% (the Federal Reserve’s preferred measure of inflation was 4.7% at the end of November)
• Treasury rates have already adjusted for a recession, but elevated interest rate volatility is likely to persist, and the Fed’s highly restrictive rate policy is starting to create issues in the global financial system
Below are select Bloomberg fixed income index returns thru Q4 2022 and year: “Don’t Fight the Fed”
Inflation was the primary influence on both domestic and global economic conditions in 2022 and fixed income markets suffered their worst performance in decades. The Bloomberg Aggregate Bond Index, a broad proxy for domestic investment grade fixed income assets, lost over 13% during the year.
Led by the Federal Reserve (the US Central Bank), open market asset purchases ended, the Fed’s nine trillion-dollar balance sheet began to shrink, and short-term interest rates rose precipitously during 2022 in hopes a more restrictive monetary policy would curb economic demand. In all, the Fed raised their overnight borrowing rate seven times, starting near zero percent and ending at a range of 4.25% – 4.50%. Yields on the 2-year Unites States Treasury Note (UST), 5-year UST, and the 10-year UST increased 369, 274, and 236 basis points, respectively, from where they ended in 2021. As a reminder, bond prices move in the opposite direction of interest rates, so a precipitous move upward in rates was followed by a commensurate downward move in bond prices.
Interest rates were quite volatile during Q4 with the 10-year UST yield ranging from a multi-year high of 4.24% in late October to a low of 3.42% in early December. The bellwether 10-year UST yield finally settled at 3.87% at year-end after starting the year at just over 1.50%.
Like the United States, major developed market sovereign yields were generally higher during Q4 as foreign central banks were also hiking borrowing rates to fight inflation. Note the three- month change during the quarter in the far-right column. Below are foreign 10-year yields as of 12/30/22. The 10-year UST remains one of the highest yielding bonds in the developed world. The rout in fixed income assets over the first three quarters of the year extended into the month of October on the heels of additional rate hikes and hawkish Fed-speak. Later in the month several economic data releases, including a headline CPI report indicating that inflation had retreated further than initially expected, sparked a reversal in Treasury prices that would last for the remainder of the year. Considerable rhetoric from the FOMC indicating a strong resolve to maintain its fight against inflation, no matter the short-term economic consequences, continues to stoke fears of a recession in 2023 and, counterintuitively, speculative buying in longer dated Treasury maturities, slightly mitigating year-end losses for 2022.
If inflation measures continue to decline and labor markets don’t overheat, the terminal Fed Funds rate should become increasingly visible in early 2023. Investors are currently pricing in two to three additional 25 bp rate hikes early in the year (placing overnight rates in the 5% range) while FOMC members currently project three to four, as indicated in the most recent FOMC “dot plots” graph. In following, paraphrasing the words of FOMC Chairman Jerome Powell, U.S. monetary policy is expected to remain “sufficiently restrictive” for “some time.” Of course, both phrases are subject to interpretation and otherwise “data dependent.” It is important to note the FOMC continues to maintain that inflation is likely to remain more persistent than what is currently reflected in most sectors of the financial markets.
In hindsight, the FOMC was too slow to remove an excessively accommodating monetary policy following the pandemic and essentially exacerbated inflationary conditions- so the question of whether the Fed will regain credibility this year is very much up in the air. As of December 2022 (the date of the last FOMC meeting) the Fed has projected a very mild recession for 2023, if one occurs at all, culminating in a year of 0.5% GDP growth, less than a 1% increase in unemployment, and a year-end Fed Funds rate of 5.00-5.25%. Given the magnitude of monetary policy activity in 2022, the speed in which rate hikes were implemented, the potential lagged effects on the U.S. economy, and the Fed’s inconsistent track record to date- forgive us if we believe “the jury is still out.”
2022 was the most challenging twelve-month period for fixed income in many decades. The result of years of central bank “yield repression” and hyper-aggressive fiscal and monetary stimulus in the wake of the global pandemic, the paltry cash flows from most fixed income assets simply could not make up for market price adjustments as rates rose in historic fashion. As a reminder, the S&P 500 Index, a broad proxy for high quality domestic equities, retreated more than 19% in 2022, and was down more than 25% during the year, so relative returns from most fixed income sectors easily bested those from equities in general. At Argent, our general fixed income positioning was more conservative in both credit quality and duration for most of the year, waiting for opportunities and additional clarity on the path of rates and the economy. Subsequently, although it was a challenging year, our clients, on average, experienced less pain than the broader markets.
We believe 2022 was a pivotal year for fixed income. An excruciating, but much needed, reset in rates has begun to normalize fixed income markets allowing for more generous cash flows and more predictable long-term performance. In following, although longer dated Treasury rates continue to look rich, we expect core fixed income to regain its function as a buffer offsetting risk of more aggressive allocations in our client portfolios. Depending upon credit quality and duration, we are starting to see more reasonable and positive “real returns” available (net returns adjusted for inflation) in numerous sectors of fixed income- both high quality and more speculative.
That said, legitimate questions remain regarding both the persistence of inflation and the Fed’s resolve to restore price stability in the U.S. Trepidation over another Fed “mistake,” geopolitical issues in eastern Europe and China, as well as the health of the global economy in the wake of higher interest rates will continue to be the major influences on the financial markets in 2023. We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts further.
Not Investment Advice or an Offer | This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.
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