2022 has been challenging for bond investors as a significant rise in interest rates has put bond market returns firmly in the red. As of April 20, the broad U.S. fixed income market was already down -5.99% YTD as measured by Vanguard Total Bond Market Index (VBTLX), while U.S. Treasuries posted a loss of -5.29% YTD as measured by Vanguard Intermediate-Term Treasury Index (VSIGX).

Why have we seen such poor performance from bonds?

The poor performance has been driven by a significant increase in rates due to Fed policy, or should we say the expectation of Fed policy in response to inflation. Coming out of 2021, the Federal Reserve had signaled they would likely raise the Fed Funds Target Rate three times in 2022 to combat rising inflation. As we moved further into 2022 and realized inflation continued to trend higher, the market began to alter their expectation for the path of the Fed Funds Target Rate.

The shifting expectations were clearly visible by examining Fed Funds Futures. On January 27, shortly after the Fed’s January meeting, Fed Funds Futures indicated the market consensus had shifted, and a total of five rate hikes were now being priced into the market. These expectations continued to shift upward until seven rate hikes were being priced in immediately prior to the Fed’s March meeting on March 15. These changes forced Treasury yields to rise significantly to match the market’s new expectation for the path of the Fed Funds Target Rate.

That background brings us to the recent Federal Reserve meeting. As expected, for the first time since 2018, the Fed raised the target rate 0.25% to a range of 0.25%- 0.50%. The committee also indicated that they would likely raise the target rate a further six times in 2022 which also fell in line with current market expectations. What was surprising to the market was the Fed’s very hawkish tone in their statement, along with Chairman Powell’s comments to the media, which certainly gave the appearance that the Fed was going to be more aggressive than originally anticipated when it came to battling inflation.

What does this mean for interest rates moving forward?

The market has clearly taken note of the Fed’s more hawkish stance and pivoted once again. As of March 21, Fed Funds Futures were projecting between seven and eight additional 0.25% increases in the Fed Funds Target Rate with a 0.50% hike on the table at either the Fed’s May or June meeting. In response, we have already seen a large jump in Treasury yields. Given the large amount of uncertainty surrounding the future of Fed policy, we would expect bond returns to be more volatile moving forward, and investors should be prepared for the possibility of additional negative returns if the Fed is forced to tighten monetary policy more aggressively than the market is currently expecting.

What is the outlook for inflation?

With realized inflation continuing to trend higher so far in 2022, it’s not surprising that we have seen inflation expectations move higher across the curve, with the shorter end being affected most dramatically. Although inflation expectations have risen, it is important to note that longer-term expectations remain relatively muted and within shouting distance of the Fed’s target of 2%. Much like Fed policy, there is a great deal of uncertainty surrounding inflation and we could see expectations continue to creep higher if data shows that current Fed policy has been ineffective at slowing current inflation.

What options are out there for clients uncomfortable with the current bond environment?

We still believe high-quality bonds are a vital component of a prudently diversified portfolio, as it is one of the most effective asset classes at diversifying equity market risk. Our bond portfolio philosophy, which focuses on short to intermediate maturities, has helped mitigate some of the current market risk, with the bulk of our recommended bond funds down less than the broad market. With that said, for those who might want to diversify some of their portfolio away from traditional bond allocations, an allocation to alternative investments can be a consideration.

We hope this post will provide greater clarity and context the next time you happen across inflation or rising interest rates in the news or in conversation. And as always, when you have any questions about your investments, need to inform us of family or work-related changes, or want to discuss your financial planning needs, please reach out. We are ready to help.

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