The silver lining of bond market clouds

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The sell-off in the bond market was almost unprecedented. The return of the American aggregate bond index (AGG) was -14.6% during the first three quarters of the year. This is one of the worst 9 month streaks ever recorded. In recent stock market sell-offs, fixed-income securities were used to offset losses. Not this time.

The Federal Reserve has targeted persistent inflation with sharp and frequent increases in short-term rates – hammering fixed income securities across the credit and maturity spectrum. There was no place to hide. But does that mean the bond market has nothing to offer for the foreseeable future? This article will review bond performance in the context of history to answer this question.

US bond markets generated generally positive returns. The recent 4-decade bond boom was fueled by a secular decline in interest rates, culminating in the zero-interest regime of the pandemic. Today, real and expected interest rates were raised rapidly following aggressive intervention by the Fed.

The following chart illustrates the expected yield (yield to maturity) of 2-year Treasury bills and investment-grade corporate bonds relative to contemporary inflation expectations. This last value is the Cleveland Fed’s 2-year forward inflation forecast based on a combination of market and survey data. Low interest rates in the post-2008 period have rarely offered holders of short-term bonds the opportunity to beat inflation…until very recently.

Chart: The expected yield (yield to maturity) of 2-year Treasury bills and investment-grade corporate bonds versus contemporary inflation expectations.

St. Louis Fed

You will notice that the rapid sell-off in recent months has tilted expected returns decisively ahead of inflation expectations. To many, this seems surprising given reported inflation figures above 8%.

These are just titles. The media usually reports the latest realized inflation compared to the previous 12 months. No problem with that. However, it fails to capture the most recent price trends. The left column of the table below lists rolling 12-month inflation for each month over the past two years. You will notice that this is a smoothed measurement that has consistently stayed above 8%. The current inflation figures are largely attributable to price increases at the start of the year which have not yet passed the 12-month observation window.

The observations in the rightmost column are annualized measures of inflation based on only on the seasonally adjusted monthly price change. It’s much closer to capturing current trends. The last 3 months indicate that inflation is running out of steam after peaking in June.

table: rolling 12-month inflation for each month over the past two years.

BLS

Forward-looking measures of inflation also point to continued price stabilization. The Treasury yield curve and inflation swap market price inflation are in equilibrium over the next 12 months at 2.65%. The aforementioned Cleveland Fed integrates surveys with market data and forecasts a 4.2% increase in CPI over the next year.

In both cases, expected inflation is significantly lower than the overall data presented to the public. 2-year corporate bonds are now yielding over 5%, well above most measures of expected inflation. This part of the yield curve is easily investable. Vanguard offers a constant maturity bond fund with a duration of 2 to 3 years (VCSH). Invesco has a low-cost ETF (BSCO) of bonds maturing at the end of 2024. The latter product’s uniform bond maturity dates largely anchor its residual value.

Of course, it’s time it could be different. A unique artifact of today’s environment is a spike in inflation. We could consider the past behavior of bond markets in the 12 months following previous inflation peaks. The data is at least slightly reassuring. Bonds and equities do not seem to suffer from the “hangover” effects of rapid price increases. In fact, average bond yields exceeded their benchmark yield over the review period.

table: past behavior of bond markets in the 12 months following previous inflation peaks

black rock

Another facet of today’s yield curve is its recent inversion. Short-term rates are now higher than long-term rates. Specifically, the 2-year Treasury yield jumped well above the 10-year yield just a few months ago. It’s the biggest reversal since the dotcom collapse at the turn of the century.

Investors can now invest in high-quality bonds with minimal term structure risk and expect to earn a return above inflation. This opportunity has been missing since the Great Recession.

One might reasonably ask whether current returns are a viable predictor of realized returns over the long term. Of course, no one can predict the evolution of interest rates. But there is evidence that starting yield in the bond market is correlated with future yields. Below is a simple illustration that tracks the observable return of 10-year Treasury bills against subsequent 10-year returns of the Aggregate Bond Index (AGG) – an indicator of high-quality US bonds. His last sighting was in September 2012. There is a lot of correspondence. The best predictor of future returns is current performance.

Chart: Simple illustration that tracks the observable 10-year Treasury yield against subsequent 10-year returns in the Aggregate Bond Index (AGG)

PIMCO, DFA and St. Louis Fed

In summary, today’s US bond market is poised to generate returns that exceed rational inflation expectations. Bond prices today are about as favorable as they have been in 15 years. There are of course no guarantees. But the weight of (admittedly limited) historical evidence suggests that bonds should provide gains that improve investors’ purchasing power.

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