The bond market experienced its worst quarter in decades

The worst quarter for US bonds in more than 40 years has come to an end. For many investors, the question now is whether it’s time to buy the biggest drop in recent memory.

The Bloomberg US Aggregate Bond Index — mostly U.S. Treasuries, highly-rated corporate bonds and mortgage-backed securities — is down 6% for 2022 through Wednesday and was on track for its biggest quarterly loss since 1980.

Yields on short- to intermediate-term Treasuries — which rise when their prices fall — have posted their biggest quarterly gains in decades, with the two-year yield rising the most since 1984 and the five-year yield the most since 1987.

Poor bond performance has robbed investors of a traditional haven at a time when stocks and many other markets have been volatile, thanks to factors such as the US Federal Reserve’s first rate hike since 2018 and the war in Ukraine.

Treasury yields largely reflect expectations about average short-term interest rates over the life of a particular bond. Investors have raised those expectations dramatically over the past three months — driving bond prices down and yields up — thanks to a string of high-inflation gauges and Fed officials sounding increasingly worried about the data.

Longer term, higher interest rates could curb inflation and possibly even push the US economy into recession, which would be better for bonds than most other assets. In the meantime, however, some analysts are warning that interest rate expectations could continue to rise, which could lead to further losses for bonds.

Tom Graff, head of fixed income and portfolio manager at Brown Advisory, said he doesn’t expect much more gains in longer-term yields in general. Short-term yields could rise slightly further as the Fed continues to raise interest rate forecasts.

“A lot of money has been lost in the bond trading world betting on the Fed’s hawkish stance,” he added.

Currently, interest rate derivatives show that investors now expect short rates to hit 3% next year – a rise of less than 0.5% now and close to zero ahead of the Fed’s latest move.

Nonetheless, investors also expect that once rates have reached that level, they will quickly come back down. Embedded in this view is the lingering belief that inflation – now at 7.9% at a 40-year high – will largely ease on its own as businesses increase the supply of goods and consumer spending as the effects of the emergency ease ease government spending programs. Many investors also doubt that the economy can handle 3% interest rates without a significant slowdown.

As a result, the yields of some shorter-dated Treasuries, such as the three-year bond moved slightly above that of longer-dated bonds such as the 10-year bond, creating what is known on Wall Street as a flat or inverted yield curve.

In contrast, some economists on and off Wall Street have argued that interest rates are likely to rise much higher than 3% because nothing less will be able to solve the inflation problem.

The yield on the benchmark 10-year US Treasury bond settled at 2.324% on Thursday, down from 1.496% late last year and a record closing low of 0.501% at the start of the pandemic, when investors thought it would be many years before the Fed doing so would raise rates again.

Unfortunately, the longer they waited, the more painful it became for fund managers to adjust their expectations.

In general, slowly rising bond yields are a “great environment for bond investors” as managers can use the cash flow from interest and principal payments to buy new higher-yielding bonds, said Vishal Khanduja, fixed income portfolio manager at Morgan Stanley Investment Management. However, a sharp rise in yields — and a fall in prices — within a few months makes it impossible to absorb losses in this way.

The Federal Reserve’s primary tool for steering the economy is the change in the Federal Funds Rate, which can affect not only the cost of borrowing for consumers, but also broader business decisions, such as B. the number of employees to be hired. WSJ explains how the Fed manipulates this one rate to control the entire economy. Image: Jacob Reynolds

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