2022 was the worst year on record for bonds. Despite a promising start, 2023 is starting to look rough, too.
The recent global bond rally appears to be tapering off as investors are getting a cold wet dose of reality about Fed rate hikes.
Bad news for bonds could spell bad news for stocks: Bond yields, which move in the opposite direction of prices, represent the opportunity cost of investing in equities — if a bond is yielding more than equities, it’s generally more attractive, because it comes with less risk than stocks. After all, Treasuries are backed by the US government. Bonds compete with stocks for investors’ dollars, and when yields go up, equities often go down.
What’s happening: Persistent inflation and strong economic data signals that interest rates are going higher and will stay there for longer. That tonal shift has sent stocks lower and Treasury yields higher, as investors rethink their views on the path of interest rates. US stocks had their worst week of the year last week, and Monday’s feel-good rebound fizzled out at the end of the day.
Just look at US short-term bonds, which closely track investors’ interest rate expectations: Two-year yields began Monday at their highest level since July 2007, before easing a bit.
What went wrong: Wall Street jumped head first into the bond market during the first few weeks of 2023, sending yields lower, as investors became convinced that the Federal Reserve’s painful rate hiking regimen would finally be coming to an end.
After a particularly tough 2022 (US Treasuries recorded their worst year in history), investors reversed course. Falling yields pushed up stocks, creating the giddy highs we saw, but that all reversed in February when we got the good news/bad news on jobs and retail sales data. The bond market (and equities) have now basically done a 180.
The yield on 10-year Treasury notes increased toward 4% last week, the highest it’s been since 2008. Last week also marked the first time in 2023 that returns on Treasury investments have turned negative.
At the end of January, the market was pricing the peak Fed funds rate at under 5%; Now it’s almost half a percentage point higher than that.
“The general view is that the market wasn’t listening to the Fed” when it made its surprisingly high rate projection in December, said Kit Juckes at Societe Generale.
The market “is listening now,” Juckes said. If anything, investors think the Fed might have undersold how high rates need to go.
Why it matters: The Dow, which has fallen for four weeks in a row, is now in negative territory for the year as bond yields continue to rise.
The best opportunity for investors is in bonds, not equities, say experts:
A team of JPMorgan strategists led by Marko Kolanovic echoed that sentiment. “The risk-reward of holding bonds at this level of short-term yields looks better than [equities] than any time since the great financial crisis,” they wrote in a note.
