“The Fed, Inflation and Interest Rates – What’s Next for Bonds?”
As we all know 2022 has been a volatile and challenging year for investors with both stocks and bonds declining by double digits, a rare occurrence. In fact, this has happened only 8 times since 1926. The catalyst for falling bond prices this year has been multiple rate increases from the Federal Reserve in an attempt to bring down inflation. From early 2022 until now, short term interest rates have risen dramatically, from .25% to 4.50% following the .50% rate hike in December. Depending on the how quickly inflation eases, the Fed has made it clear that future rate decisions will be based on the data. Approaching the end of rate hikes is important because stable interest rates and falling inflation should be strong positives for both stocks and bonds.
Bonds. Bond prices typically rise and fall for one of two reasons – either interest rates in general are rising or falling or the credit quality of an issuer/borrower has improved or deteriorated, or is expected to improve or deteriorate in the near future. The rapid rise in short term rates this year led to a historic decline in bond prices with the Bloomberg Aggregate Bond Index down as much as 16% this Fall but now down only 11.8%% (through December 21, 2022). This is the most significant loss for bonds since 1931. At this writing the benchmark 10-year Treasury Note is yielding 3.51% after being as high as 4.23% in October. As painful as this year has been for bond investors most analysts think the worst is probably over for bond owners. When interest rates stabilize, bond prices also tend to stabilize with bonds performing well over the subsequent 12 to 24 months. In fact The attached table reflects how bonds have performed historically after a calendar year of negative returns:
As you can see during years when bonds posted losses, those losses were usually quite modest, averaging a decline of just 3.30%. In contrast, the average investment return produced by bonds over the two calendar years following negative years was 9.96% with the median return being 8.85%. The highest two-year return was 37.51% and the lowest return was 5.14%; there were no periods of negative returns.
Please keep in mind that this data isn’t meant to predict how bonds might perform in the near future because predicting either stock or bond market performance over the short term is impossible. However, the past, with almost a century of data to rely on, is often our best guide regarding what the future might hold.
Inflation and the Federal Reserve. As we all know, inflation rose to a 40 year high in 2022 but is, fortunately, finally declining with year-over-year CPI recently falling to 7.1% from over 9.0% in June. Many commodity prices have been “rolling over” and housing is clearly beginning to cool off. Even with a national shortage of available housing, 30-year mortgage rates in the low 6% range, compared to 3% just 11 months ago, has dampened demand for home purchases and impacted home prices. As a quick reminder, the textbook definition of inflation is a general rise in the price level of goods and services caused by “too many dollars chasing too few goods”. In 2020 when the pandemic and widespread shutdowns wreaked economic havoc on the country resulting in millions of lost jobs, the Federal Reserve and Washington responded aggressively. On the monetary side, the Fed slashed interest rates and began increasing the money supply by buying bonds, also called “quantitative easing”. On the fiscal side, Washington responded by having the Treasury send money directly to businesses and consumers via PPP loans, stimulus checks, enhanced unemployment benefits, etc. This massive increase in liquidity, approximately $5 trillion, from both monetary and fiscal stimulus, created the “too many dollars” portion of the inflation equation. At the same time America was grappling with supply chain issues, rounding out the “too few goods” part of the formula. It isn’t hard to see why we had inflation at 40 year highs.
What is CPI, How is it Calculated and Why is Inflation Falling? Some economists consider some of the data used by the Bureau of Labor Statistics to calculate the CPI (Consumer Price Index) as “stale” and not necessarily reflective of current market conditions. For example, housing comprises 30% of CPI; not actual home prices but something called “owner’s rental equivalent”. Some of the leases included in this data were signed as much as 6 or 9 months ago and don’t reflect recent softening in the housing market and in declining rents. In fact, if housing is removed from CPI, we see a disinflationary trend from the other components of CPI, especially energy. With regard to housing, in early December home sales volume was down 28.4% from a year ago. In addition, banks have been tightening underwriting standards and becoming much more selective with their approvals.
As to the money supply, the Fed was buying as much as $120 billion of bonds per month in 2020 to provide liquidity to the financial system and keep interest rates low. This ended in March of 2022 with the Fed now actively reducing the money supply by allowing bonds on their balance sheet to “roll off” as they mature and not replacing them. Since April, this roll off has shrunk the Fed’s balance sheet by close to $400 billion, reducing the money supply as intended. This roll off should continue at a pace of approximately $95 billion per month into 2023, which equals about 1% of the Fed’s balance sheet. This is referred to as “quantitative tightening”. Fewer dollars chasing more goods is disinflationary, which is what the Fed hopes to accomplish.
In summary, we think inflation should decline substantially over the next 3 or 4 quarters although getting to the 2% Fed target inflation rate could take a very long time. Lower inflation should be a positive for both stocks and bonds in 2023.
What If the Fed Tightens Too Much and We End Up in Recession?
The majority of economists believe a recession is likely sometime in 2023 while acknowledging that a “soft landing” is still possible. Rather than debating the technical definition of what is and is not a recession, we prefer to focus on the likelihood that growth will slow in 2023 and may even be flat and that corporate earnings are also likely to grow modestly or be flat, at least in the first half of 2023. If the economy slows too much, the Federal Reserve playbook to deal with economic contractions is pretty predicable – reduce short term interest rates and possibly increase the money supply through quantitative easing (bond buying). Declining interest rates and an increasing money supply is generally bullish for both stocks and bonds.
• Very soon the Fed will stop raising short term interest rates (bullish indicator).
• Inflation should continue to decline through 2023 (bullish indicator).
• We may or may not experience recession in 2023 (could be a short-term negative for stocks).
• Employment remains robust (bullish indicator because employed people spend money).
• Inadequate legal immigration is creating a shortage of workers (wages will remain high but corporate productivity and earnings may suffer – could be bearish).
• The dollar may continue to weaken from the highs reached in recent months (bullish for multi-national American based companies).
• The third year of the Presidential cycle has historically been the best year for stocks during a four-year Presidential term (returns of 16% plus for the S&P 500 versus 10% for all years). 2023 is the third year of President Biden’s term (bullish indicator)
• A deeper than expected recession could cause a sharp decline in earnings (bearish indicator over the short term).
In closing, as always, an investor’s most important weapon for long term investing success is patience. Economic expansions and contractions and market cycles come and go but for 150 plus years, stocks have always eventually resumed their inexorable march higher, driven by higher earnings and higher dividends. It’s crucial to remember that stocks – and to a certain degree bonds – should be viewed as long term, multi-year investments. Investment returns produced by stocks over any short period of time, good or bad, should have nothing to do with an investor’s decision to own equities. In this case, short term means 2 or 3 years. Whether someone is age 35, 55 or 75, we are all long-term investors, although some investing time frames are longer or shorter than others.
Always remember that well thought out, properly constructed and carefully executed long term investment plan only works if it’s used as intended. Try your best to shut out the cacophony of mostly useless financial noise that passes for financial media, remain disciplined in your approach and let the markets do the heavy lifting for you.
Thanks everyone. As always, we appreciate your trust, your confidence and your business. Have a wonderful Holiday Season and a safe and fun New Year.
The Sutton Wealth Advisors Investment Committee
W. Edward Sutton
Zachary Sutton, CFP®, EA
Derek R. Gage, CFA
The information contained herein (1) is intended solely for informational purposes; (2) is not warranted to be accurate, complete, or timely; and (3) does not constitute investment advice of any kind. Neither Sutton Wealth Advisors, Inc. nor Purshe Kaplan Sterling Investments is responsible for any damages or losses arising from any use of this information. Past performance is not a guarantee of future results.
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