1. Bond returns tend to be strong after down years.
2022 was the worst year for core bonds in almost half a century, as the U.S. Aggregate declined by 13% on the back of the Fed’s most aggressive rate hiking campaign since 1980. Bonds tend to come under pressure when the Federal Reserve is active; 1994, 1999, 2013, and 2018 were all years in which the Federal Reserve was raising rates or communicating they would tighten policy.
Encouragingly, however, the years following bond market declines tend to see healthy returns. Though core bonds logged negative total returns in both 2021 and 2022, with the Fed likely to conclude its rate hiking cycle in 2023, interest rate volatility should decline allowing for some much-needed stability in the bond markets.
2. Inflation is showing clear signs of moderating further.
The inflation heatwave that prompted aggressive Fed action should cool considerably in 2023. In fact, disinflation is now evident in most CPI components; supply chain pressures have eased noticeably allowing for core goods prices to come down, energy inflation continues to deflate alongside falling gas prices, and shelter inflation—which accounts for more than 1/3 of CPI—should decline in 2023 on the back of lower home prices and lease rates.
Interestingly, year-over-year spikes and declines in inflation tend to look like the Eiffel tower: it goes up and comes down symmetrically, meaning prices decline as quickly as they increase. From our vantage point, the other side of the inflation tower should continue to crystallize in 2023.
3. Slow growth and falling inflation suggests the Fed can be less aggressive.
Historically, policy rates tend to go up by the escalator and down by the elevator. The challenge last year was that the Fed took rates up in the elevator to kill inflation, spooking the bond market. We expect the Fed will pause this year as inflation cools and growth slows, and eventually ease policy in late 2023. This should translate to a boost in bond prices.
While slower growth and falling inflation suggest the Fed can be a bit more cautious in 2023, whether or not the Fed begins cutting rates in the second half of the year is still unclear. Still, the Fed is almost done tightening, suggesting monetary policy will be increasingly sensitive to economic fundamentals such as softer growth and cooler inflation.
4. Valuations have reset across the board, particularly in bonds
Last year, elevated volatility led valuations to reset across the capital markets. As the dust settles, bonds are looking outright cheap relative to the past 20 years, with valuations in U.S. Treasuries and core fixed income a standard deviation below their long-run average. This has presented an attractive entry point for investors. Moreover, it could be some time before yields are as attractive as they are today. Bond yields should decline as growth slows, inflation cools, and the Fed prepares to ease policy, suggesting a small window for investors to lock in these juicy yields and benefit from any subsequent decline.
5. Bond yields are attractive relative to recent history.
Diving in, bond yields across a variety of sectors are attractive relative to recent history. The grey bars show the range of yields over the past decade, the light purple bar shows the median, and the dark blue diamond—which reflects current bond yields—represents the current reading. In all cases, the blue diamond is above the purple line, indicating that bonds are attractive.
Importantly, current yield levels are a strong predictor of future fixed income returns. For context, if investors were to buy the Bloomberg U.S. Aggregate at a yield of 4.5-5%, historical relationships suggest a potential total return of ~5% annualized over the next cycle. With the trailing 5-year return on bonds now flat against a backdrop of elevated yields, core bonds represent an attractive opportunity on a forward looking basis.
