Baird Advisors: Bonds are Back

Following a period that has been called “pretty much the worst bond market ever,” an aggressive course of treatment by U.S. monetary policymakers saw short-term interest rates climb from zero to 5.25% in about 360 trading days. Now bond investors are beginning to see the benefits. Against a backdrop of sustained economic growth and softening inflation, real yields are in positive territory for the first time since late 2019.

To better understand what the future might hold for those investors, it’s important to understand how we got here and the forces still shaping the market today.

Relearning to listen to the Fed

A vital game of macroeconomic tug of war has been playing out in 2023 between a remarkably resilient U.S. economy and a Federal Reserve that is equally resolute in its effort to rein in inflation.

For interest rates, this dynamic pits downward and upward forces against each other. Declining headline inflation, recessionary signals (most conspicuously a yield curve that’s been inverted for more than a year), tightening lending conditions, and secular demand from fixed-income investors exert pressure to push down rates while solid economic growth and a tight labor market have served to support higher yields.

Similarly, corporate credit spreads are sensitive to those opposing forces as well. Risks of recession and tighter lending conditions should act to push spreads wider, while strong borrower fundamentals and persistent investor demand for extra yield keep spreads in check.

Most market participants have finally quit pining for an early Fed pivot to lower short-term rates and instead have remembered how to listen to the Fed. The central bank’s mantra that it is disinclined to ease until above-target inflation is clearly eradicated is finally sinking in with investors who had been questioning its commitment to the fight and interpreting any softening of economic data as an opportunity to pile back into higher-risk assets.

To be fair, the Fed does appear at or close to finishing up its current round of rate increases, so it’s logical to ask how long they might continue. But the parlor game of guessing what Fed Chairman Jerome Powell is thinking privately seems to be giving way to listening to what he is saying publicly.

Some degree of this “will they or won’t they” tension is still contributing to uncertainty for investors and elevated volatility in Treasury yields. Other lingering questions include: Can the Fed avoid a recession and pull off a soft landing? Will it remain dogmatic about reaching its 2% inflation target? And what about the potential for forces beyond domestic control to cause dislocations (specifically, Vladimir Putin’s humiliation in Ukraine, China’s slowing economic growth and the realignment of supply chains along regional axes after the pandemic laid bare the vulnerabilities of the global system)? 

A bright economic picture with some shadows

After a pandemic related slowdown that was much greater—but far shorter lived—than the Great Recession, the U.S. economy reopened and roared back to life in 2020/2021, resulting in the inflation spike that crushed bonds in 2022.

But 2023 has seen economic growth closer to its long-term trend of roughly 2% per year, a pace that implies moderate inflation. Slow labor force growth and onerous debt service at the Federal level will keep a lid on potential GDP growth over the long term, even as its potential inflationary impact causes near term heartburn.

Inflation has softened considerably from its late 2022 highs, but the headline CPI figure is still at 3.2% and the Fed’s preferred inflation barometer, personal consumption expenditure, is 1% higher than CPI. Meanwhile, the job market remains extremely tight (a condition that has not been lost on Fed policymakers or union wage negotiators).

Predictably, slowing growth is manifesting in most corners of the economy, but most sectors are coming off healthy levels:   

• U.S. consumers—especially the large numbers who took advantage of low mortgage rates to buy or refinance a house and are sitting on record amounts of home equity--are in reasonably good shape. Consumer debt is ticking up, however, and that uptick bears watching, especially now that households have largely burned through the pandemic stimulus cash they received and, for many families, student loan payments are resuming.
• Notwithstanding a few high-profile bank closures, U.S. commercial banks are in good shape overall too. While deposits have fallen somewhat with a rotation to higher-yielding money markets, banks’ deposit base remains near record levels and loan charge-offs, even in the beleaguered commercial real estate sector, remain comfortably below historical averages.
• Investment grade companies have similarly healthy balance sheets, with robust top- and bottom-lines and plenty of cash on hand to service the low-cost debt they smartly issued when rates were much lower.
• Similarly, between federal largesse during the pandemic and shrewdly borrowing at low rates, state and local governments are sitting on significant rainy day cash reserves (a national median of nearly 14% of expenditures, versus less than 8% five years ago) and, with a few notable exceptions, have funded their pension obligations responsibly.
• One sector of the economy that is undeniably under stress is commercial real estate. With the work-from-home movement, vacancies are still uncomfortably high and the average coupon on floating rate commercial mortgage loans has skyrocketed from 2.78% at issuance to 7.54% at maturity.

The upshot for bonds

With generous fixed income yields outpacing equity dividends, investors are noticing a compelling opportunity and finding it easier to overlook day-to-day price volatility. Compare the $345 billion in outflows fixed income saw in 2022 to the $174 billion that has moved into fixed income funds year-to-date. But with echoes of the pandemic reverberating in the economy and contorting the yield curve in sometimes unexpected ways, it still pays to be active and selective.

Note: this article was originally published October 6, 2023 and was updated on October 19, 2023.