Bonds Look Strong

Investing in bonds didn’t pay off in 2022, but three factors may combine to change that this year

By Christopher Vecchio

Even though equity markets declined by double digits last year—more than 20% in some cases—the bond market didn’t provide a bastion of safety.

In fact, the S&P U.S. Aggregate Bond Index was down more than 11.5% at the end of the year. From U.S. treasuries to investment grade to high yield, it was a bad time through and through.

But the disappointment of 2022—spurred by multi-decade highs in inflation and the most aggressive central bank rate hike cycles since the 1970s—may be a relic of the past.

The groundwork is laid for 2023 to be a better year for bonds, especially for U.S. treasuries, including two-year (/ZT), 10-year (/ZN), and 30-year (/ZB). Let’s examine three reasons why.

The “Fed ratio” perspective

Bond yields will outpace stock earnings and dividend yields this year. That’s unusual because equity markets have tended to produce a higher annualized return than treasuries since the end of World War II.

The groundwork is laid for 2023 to be a better year for bonds, especially U.S. treasuries.

However, stocks also carry more risk than bonds and thus returns on stocks have been more volatile. Specifically, the standard deviation of stock market returns has been higher than those of the bond market.

But the expectation of higher returns on stocks makes them a potentially more appealing investment than bonds.

The Fed model measures the trade-off by comparing the earnings yield (E/P; the inverse of the P/E ratio) of the S&P 500 to U.S. Treasury 10-year yield.

As long as the earnings yield of the broader stock market remains higher than the yield on bonds, it would follow that investors would favor stocks over bonds.

But if the S&P 500’s earnings yield drops below the U.S. treasury 10-year yield, why would investors take on additional risk to earn a lower return?

Much-maligned federal policymakers may have been right when they called inflation “transitory.” It may return to 2% to 4% by mid-2023.

The U.S. treasury 10-year bond and 30-year bond yields began this year at 3.880% and 3.975%, respectively. By comparison, the Dividend Aristocrat ETF (NOBL) had a dividend yield of 2.6% heading into 2023.

The S&P 500 (/ES) has a P/E ratio of 19.97, providing an earnings yield of 5.01%. For many investors, the close proximity of U.S. treasury yields to earnings yields and dividend yields will make them alluring, particularly at the long end of the yield curve (/ZN and /ZB).

The end of rate hikes

The Federal Reserve may raise interest rates a few more times this year but not much more than that.

Even so, with the Federal Open Market Committee outlining its case in December 2022 for its main rate to end 2023 at 5.1%, interest rate markets aren’t in agreement.

In fact, according to Fed fund futures, the Fed’s main rate will peak at 4.92% by the middle of this year before subsiding to 4.55% by the end of December. (See chart.)

Assuming the market is correct, the short end of the U.S. treasury yield curve may not feel significant upward pressure (i.e., further decline in prices) much longer.

Fed policy, aimed at the short end of the yield curve, tends to have a greater impact on two-year notes (/ZN) than on those at the long-end of the yield curve. Two-year notes, which lost 6% in 2022 as the two-year yield rose from 0.766% to 4.428%, may be poised to rally—particularly in the second half of this year.

Less inflation

Federal policymakers were maligned last year for calling inflation “transitory.” But they may have been right, and it’s just lasting longer than anticipated.

Sharp deceleration in price pressures over the past few months may return inflation to 2% to 4% by mid-2023.

Coupled with the prospect of an economic slowdown and potentially a recession this year, the long end of the U.S. treasury yield curve, with elevated interest rates in both real and nominal terms, may offer great value heading into next year.

The long end of the U.S. treasury yield curve captures both growth and inflation expectations, which have been subsiding in recent months.

Ten-year notes (/ZN), which lost 13.93% in 2022 as the 10-year yield rose from 1.513% to 3.880%, and 30-year notes (/ZB), which lost 21.87% as the 30-year yield rose from 1.902% to 3.975%, may be positioned for a strong performance throughout 2023.

Christopher Vecchio, CFA, head of Futures & Forex at tastylive, forecasts economic trends in a number of countries. @cvecchiofx