Investors were able to breathe a sigh of relief in 2023, not only because of big gains in stocks, but also because the bond market ended a two-year losing streak. However, bonds’ path to positive returns last year proved difficult. By some measure, the bond market has been more volatile than it has been in any other year in at least the last decade.
Now, with the Federal Reserve appearing poised to cut interest rates in 2024, observers expect some of that volatility to fade. But there is enough uncertainty that investors probably shouldn’t expect a return to the relatively calm conditions seen in bonds during the period from the 2008 financial crisis to early 2022.
This post-crisis period “was an abnormal time,” according to Stephen Bartolini, who manages U.S. core bond strategy at T. Rowe Price. The return to generally higher interest rate levels is accompanied by a greater magnitude of price fluctuations, he says. “We are back to a more normal regime of volatility.”
How volatile have bonds been?
Large price swings are not what most investors associate with bonds, especially government bonds. Bonds are considered safer than stocks, and most investors view them as ballast, providing stability to their portfolios against fluctuations in riskier investments like stocks.
In 2022 and 2023, this was far from being the case. The extreme volatility of bonds can be seen through standard deviation, which measures the variability of returns. The lower the standard deviation, the narrower the performance range. From 2014 to the end of 2021, the quarterly standard deviation of the Morningstar US Core Bond Index averaged 0.2. In contrast, the stock market, as measured by the Morningstar US Market Index, recorded an average quarterly standard deviation of 0.94. For 2022-23, the average bond standard deviation more than doubled to 0.45. Stock market volatility also increased, but to a lesser extent, reaching 1.2.
Why have bonds been so volatile?
Much of the blame lies with inflation, the economy and the Fed’s policy outlook.
Bartolini focuses first on a return to fluctuations in inflation. “Inflation volatility was latent during the post-[2008 financial crisis] period,” he said. “Obviously some have pretty strong backs.”
From 2010 to 2020, for example, inflation as measured by the Consumer Price Index largely held steady at an annual rate of between 1% and 3%. This trend goes back even further. From 1984 to 2020 (except for a short-lived period around 1990), inflation remained within a range of approximately 1.50% to 4.25%. (From 1970 to 1980, inflation varied between 3.3% and 13.5%).
In 2022, as inflation reached its highest level in four decades, the Fed raised the federal funds rate at an unprecedented pace and bond volatility surged. These wild price swings have continued into 2023, as investors’ expectations for Fed rate hikes and cuts have oscillated.
The important context for bond investors is that for much of the post-financial crisis period – those years when inflation was low and stable – the Fed kept interest rates extremely low. This included two rounds of quantitative easing, in which the central bank injects money into the banking system through bond purchases. The result was that the Fed kept bond yields, and thus bond market volatility, in check.
“At this point, most investors have lived much of their careers between 2008 and 2020, when returns were artificially suppressed due to ultra-accommodative policy via the funds rate and quantitative easing, which which certainly removed volatility. [on long-term bonds]said Ricky Williamson, chief investment officer for Morningstar Mutual Funds at Morningstar Investment Management.
The big swings in Fed rate expectations in 2023
The Fed’s move away from interest rate capping began in 2022, but 2023 saw extreme shifts in expectations about the central bank’s policy outlook, which carried over into the bond market.
In 2023, “we’ve had four years in one” when it comes to Fed expectations, says Lindsay Rosner, head of multi-sector fixed income investing at Goldman Sachs Asset Management. “There were four different regimes, and I think that led to the volatility that you saw.”
At the start of the year, investors were preparing for continued sharp rate hikes. Then came the collapse of the Silicon Valley bank and fears of the economy falling into recession, which shifted expectations in favor of Fed easing. Then came summer, and the economy not only avoided recession but accelerated, with the Fed continuing its rate hikes and signaling more through the end of the year. During the summer sell-off, bond yields rose to a 17-year high, with the yield on the 10-year U.S. Treasury note hitting 5%.
That all changed again in the fourth quarter, as evidence of continued moderation in inflation, coupled with a cooling of the red-hot jobs market, brought back expectations of Fed easing. This was confirmed in December when the Fed indicated that it planned to cut rates in 2024.
What’s Next for Bond Volatility
Bartolini expects bonds to remain relatively volatile, but for a different reason. “There is potential in 2024 for a transition from inflation volatility to growth volatility,” he explains. “Inflation has declined significantly over the past three to six months, and is expected to remain relatively subdued from now on.” Instead, he thinks investors are more likely to be wrong about their expectations about the pace of economic growth.
Currently, the consensus is that the economy will experience a soft landing, meaning the Fed will succeed in lowering inflation without a recession. For Bartolini, this has already happened: “This is what a soft landing looks like. We live it.
He continues: “If we think about how to structure portfolios for the next three, six or 12 months, we need to think about tail risks. » In other words, we should think about what investors typically don’t expect.
So the risk lies in what happens from there. Will the economy tip into recession due to the delayed impact of the Fed’s rate hikes or some renewed problems in the banking sector that are not apparent today? “The alternative is that we have had a substantial easing of financial conditions which, in the right environment, could lead to an acceleration of growth, which would be well outside the consensus,” Bartolini believes.
Rosner thinks bond market volatility should ease somewhat from the extremes of 2023, but she also reminds investors to think about what might go wrong in terms of expectations. She notes that investors seem to be banking on the economy performing well, a “perfect soft landing.”
She says: “The ability of central banks to make this change and start cutting rates depends on growth at or slightly below trend. This won’t work if growth rates start to accelerate, because then they won’t be able to cut rates with confidence. On the other hand, the policy that has been drawn up also makes no sense in the event of a growth shock and entry into recession.”
Opportunities for bond investors
In this context, Rosner believes that some good news is that even with larger price swings, it makes sense for investors to consider exiting cash when they have enjoyed higher yields and security. facing the storm of rate increases.
“It’s impossible to pinpoint exactly when you’re supposed to extend, but we think it generally makes sense to extend…in the short to mid end of the bond market,” Rosner says. Moving to bonds with a maturity range of two to four years will offer attractive additional yield, she adds.
Bartolini has no strong bias about the likely outcome of the economy. Instead, he’s looking for ways to build a portfolio with a mix of items — some that could benefit from a weaker economy, and others that would perform well if growth turns out to be stronger.
He believes Treasury inflation-protected securities, or TIPS, would be attractively priced if the economy reaccelerates. “Particularly when the Fed has a dovish bias, TIPS generally do well when we see an acceleration,” he says.
On the other side of the equation, he is betting that the slope of the yield curve will steepen from its current inverted position, in which short-term returns are higher than long-term returns. If the economy fell into recession, or if the Fed chose to cut rates more than currently expected, it would lower yields on short-term bonds relative to long-term bonds.
For the trading week ending January 12
- The Morningstar US Market Index rose 1.77%.
- The best performing sectors were technology, up 4.76%, and communications services, up 2.61%.
- The worst performing sector is energy, down 2.29%.
- Yields on 10-year U.S. Treasury notes fell to 3.95% from 4.05%.
- West Texas Intermediate crude prices fell 1.72% to $72.74 per barrel.
- Of the 844 U.S.-listed companies covered by Morningstar, 431, or 51%, were up, four were unchanged and 409, or 48%, were down.
Which stocks are rising?
Docusign DOCU, Wipro WIT, Palo Alto Networks PANW, CrowdStrike CRWD and Urban Outfitters URBN.
Which stocks are down?
Grifols GRFS, Plug Power PLUG, Tilray Brands TLRY, SunPower SPWR and Altice USA ATUS.