3rd Quarter 2022 Fixed Income Review
• Q3 fixed income markets experienced continued negative performance as inflation and labor market data proved stubbornly robust
• During the quarter, the FOMC raised the Federal Funds rate by 75 basis points at each of their July and September meetings, bringing the target range to 3.00-3.25%
• At quarter-end, the FOMC was expected to hike an additional 125 basis points before the end of the year as indicated in the September meeting
• Although some economic readings have trended lower, the core rate of inflation remains elevated and higher than the Federal Reserve’s target near 2% (the Federal Reserve’s preferred measure of inflation was 4.9% at the end of August)
• Elevated interest rate volatility is likely to persist, and the Fed’s highly restrictive rate policy is starting to create issues in the global financial system
Below are select Bloomberg fixed income index returns thru Q3 2022 and year to date:
The third quarter of 2022 continued where the second quarter left off with few, if any, sectors to hide in fixed income as the US central bank continued its fight against rising inflation, the result of excessively low interest rates and historic fiscal stimulus in the aftermath of the pandemic. As normally expected, higher credit quality and shorter duration assets performed well, in relative terms, but the best performing sectors of fixed income have still experienced mid-to-high single digit declines in market value year-to-date. An outlier, although experiencing negative double-digit returns year-to-date, was the taxable high yield sector which performed well against peer sectors during Q3 in relative terms.
At the end of September, the yield on the 2-year Unites States Treasury Note (UST), 5-year UST, and the 10-year UST rates had increased 355, 283, and 232 basis points respectively since the beginning of January. Interest rates were quite volatile during Q3 with the 10-year UST yield ranging from a low of 2.58% in early August to a fourteen year high near 4.00% the last week of September. After a wild ride the 10-year UST yield finally settled at 3.83% at the end of the quarter. Both at the Jackson Hole Economic Symposium in August, and in his press conference following the most recent FOMC meeting in September, Fed chair Jerome Powell struck a very “hawkish” tone regarding monetary policy, declaring that the Fed is “strongly resolved” to bring inflation back to 2%. He further stated that the Fed “will keep at it until the job is done.” Notably, the term “keeping at it” was used widely by former Fed chairman Paul Volker who led an historic and successful fight against inflation during the late seventies and early eighties culminating in a Fed Funds rate of 20%- as well as the recession of 1980-1982.
This “whatever it takes” sentiment was echoed recently by the Bank of England with the announcement of an emergency quantitative easing policy intended to protect UK pensions from skyrocketing British government bond yields, and a potentially imminent collapse. The BOE’s announcement resulted in the largest single day move in 30-year GILT (British government bond) yields in recent memory. The British incident is a side effect of fast-rising US Treasury yields, the ensuing strong US Dollar, and fallout from derivative strategies used widely by British pension funds to hedge against outsized moves in interest rates. How other countries, particularly in the European Union, cope with generationally high inflation, restrictive monetary policies, and the contrary urge to provide fiscal assistance during times of economic stress, remains to be seen. Additionally, financial markets continue to watch credit default swaps of Credit Suisse, a global banking institution, which appears to be under some rates-related stress as well.
According to the latest Statement of Economic Projections released by the Federal Reserve, the year-end estimate for US GDP growth was revised downward significantly for the second straight time (from 1.7% in June, to 0.2%). Unemployment expectations for 2022 and 2023 were revised upward, and Core PCE inflation projections (the Fed’s preferred measure of inflation) were raised from 4.3% in June, to 4.5%. The median “dot-plot” estimates for the year-end Fed Funds rate also increased from approximately 3.5% to 4.5%. Importantly, these forecasts suggest the Fed is willing to let the economy slip into recession to get the rate of inflation down.
Like the United States, major developed market sovereign yields were generally higher during Q3 as foreign central banks were also hiking borrowing rates to fight inflation. Note the 3-month change in the far right column.
Above are foreign 10-year yields as of 10/3/22. Although no longer at the top, note that the 10-year UST remains one of the highest yielding bonds in the developed world.
Extreme volatility in bond prices (prices move in the opposite direction of bond yields) and rapidly rising rates in the US during 2022 have already caused some stress in global financial markets. Combine that with runoff from the Fed’s $9 trillion balance sheet (referred to as quantitative tightening, or QT) beginning in the most recent quarter, and liquidity in even the largest sectors of fixed income have been negatively affected in recent months. Although labor market data and inflation measures continue to point the Fed toward a restrictive monetary policy, there are other signs of a slowing economy in the US. Recent manufacturing data and weakening consumer related metrics are clear signals that economic activity may be waning.
With mixed data signals, little clarity of outlook, and real interest rates (the rate of return after inflation) still in negative territory, our position on fixed income allocation remains cautious. In following, we continue to recommend shorter duration and higher credit quality in fixed income portfolios combined with a healthy amount of cash, cash management strategies, or “dry powder” available to be deployed opportunistically.
Although 2022 has been the most challenging environment for fixed income in many decades (the result of years of central bank “yield repression” and uber aggressive fiscal and monetary stimulus in the wake of a global pandemic) as expected, relative returns from most fixed income sectors still eclipse those from equities in general year-to-date. We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts on fixed income, and to learn more about opportunities we believe are both appropriate and timely.
Not Investment Advice or an Offer | This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent
company of Argent Trust, Heritage Trust and AmeriTrust.
For more information about the commentary found in this newsletter, please contact: Sam Boldrick: sboldrick@argenttrust.com or Hutch Bryan: hbryan@argenttrust.com
