The fixed-income selling wave has been brutal, and it brought mainstream investment-grade funds to high single-digit losses on a year-to-date basis, asserts Jack Bowers, editor of Fidelity Monitor & Insight.
Interestingly, it was not driven by inflation concerns, which eased somewhat during the month. Instead, bond investors were much more fearful of the Fed’s hawkish shift.
During most of the past year’s problematic increase in pricing pressures, the Fed seemed content with removing the monetary expansion it put in place during the pandemic (some 25% of dollars in circulation today were created — or “printed” — in 2020).
It was a straightforward approach; by getting short-term interest rates back up to a neutral level and reversing the central bank’s balance sheet expansion, inflation would be self-resolving as supply chains return to normal, labor shortages ease, and productivity investments bear fruit.
But that may not be enough. Inflation is becoming more embedded in the expectations of consumers and businesses. Today’s pricing pressures are not nearly as bad as those of the late 1970s, but they may still require the kind of thinking that Paul Volcker brought to the Fed in the early 1980s.
In other words, the Fed now seems more likely to hike short-term interest rates above a neutral level, which threatens a more substantial yield curve inversion, and the increased risk of a recession that goes with it.
Nevertheless, most of this is already factored into bond valuations, so it’s not necessarily correct to assume that additional selling will occur as the Fed executes its plan over the coming year.
We might see more panic selling, which can sometimes feed on itself. But if we get an oversold condition, it would quickly be reversed once the selling pressures ease. Bargain-hunting bond investors love situations that involve premium yields.
At this point, bonds are where they are, with trailing five-year returns that are not far from current 30-day yields. If I were to guess, the situation will look much the same five years from now, except that yields on money markets and very short-term bonds will be higher.
As such, it is harder than it looks to make a case for dumping bonds at this stage in the game. The smarter move, in my opinion, is to move further out on the yield curve where the income stream is more robust.
That way, if the Fed does purposely invert the yield curve in a substantial way, longer-duration investment-grade funds could potentially benefit — much as they have in the past when the Fed tightens past the point of neutrality.
It may also make sense to lighten up on high-yield exposure. While an inverted yield curve (with the resulting reduction in bank lending) may not slow today’s economy the way it has in the past, it could still increase credit risk, especially if overall pricing pressures ease faster than expected.
