The 4th quarter capped a difficult 2022 for financial markets. The Federal Reserve’s (Fed) campaign to combat a historic rise in inflation left investors with few hiding places from broadly negative returns. As we begin 2023, we survey a fixed income landscape with meaningfully higher yields, wider credit spreads, and further expected Fed tightening.
We also see a significant disconnect in expectations for future policy rates between the Fed and market participants. The Fed believes it can hold interest rates near 5% for most of 2023, while the market expects interest rates will have to be cut by the end of the year. This difference in expectations is bearing out in asset pricing and could be the source of more market volatility in the first half of the year.
In the following Q&A, Mike Sanders, Portfolio Manager and Head of Madison Fixed Income, shares his perspective on what could be a new era of coordinated global tightening and what it could mean for fixed income markets.
How will investors remember 2022?
Sanders: 2022 was a year of volatility in the fixed income markets. The negative returns experienced across fixed income markets in 2022 were payback for years of positive performance, mostly driven by the Fed’s policy of keeping rates artificially low for so long. For many investors, 2022 was also a reminder that not all fixed income is alike, and that certain types of fixed income can actually amplify the volatility within a portfolio.
In 2022, we saw the Federal Reserve hike the Fed Funds rate at a historically fast pace to combat inflation. However, the lag effect in monetary policy is perceived to be nine to 12 months, so it’s important that investors recognize that a lot of the moves that the Fed made in the middle of 2022, we won’t be seeing a lot of the impact until mid to late 2023.
It’s not just the Fed. Central banks around the globe have pulled a policy U-turn, moving from monetary easing to tightening.
The view so far in 2023, is that the Fed will move interest rates a few more times to reach about 5%, and then pause. From the Fed’s perspective, they want to move rates to a level that’s sufficiently tight, and then watch how the economy reacts and how the inflation dynamic plays out.
How likely is a “soft landing?”
Sanders: In our opinion, the biggest topic of 2023 is the disconnect between the Fed’s monetary policy guidance through the entire year and market expectations. The market expects that the Fed will have to cut interest rates by the end of this year, while the Fed believes that it can hold interest rates near 5%
for most of 2023. That gap is fairly large and actually increases in magnitude as you look into the market’s expectations for rates in 2024 and 2025.
The Fed will be watching the labor market closely to see whether its policy is working and whether inflation levels are easing. We think that because the labor market is fairly strong today, the lasting impacts of higher wages might be in the economy longer than what the market believes. Either way, this disconnect in expectations between the Fed and markets should drive a lot of volatility in the first half of the year.
What should investors expect for fixed income in 2023?
Sanders: Given the rise in interest rates in 2022, all-in yields are much more attractive. There’s income back in fixed income, and investors won’t have to reach as far down the quality or maturity scale to generate solid total returns – price appreciation and income. So we think you’ll see investors more comfortable reallocating to fixed income.
Even if volatility remains elevated in 2023, we believe fixed income, in general, will again act as a risk reducer – as opposed to a risk amplifier, as it had in certain sectors in 2022 – and return to its more traditional role of diversifier, negatively-correlated to equity and other asset classes.
Where do you see opportunities in 2023?
Sanders: In 2023, we see opportunities in high quality investment grade credit. We think bank debt is particularly attractive, given the spread difference between highly rated bank debt and highly rated industrial bonds. And, given the buildup of reserves over the last couple of years, we think banks will be able to withstand any sort of economic volatility in 2023 and beyond.
There’s still a lot of uncertainty in the market. Blindly buying all corporate bonds or all of a specific sector may be taking on more risk than you need to. As we saw in 2022, certain sectors became correlated with other risk assets and ended up enhancing the risk in a portfolio. Having the ability to manage all risks in a fixed income portfolio in this environment of higher volatility – credit spread volatility, interest rate volatility – we believe it does make a difference in generating risk- adjusted returns, especially as we move into 2023.
Disclosures
Any performance data shown represents past performance. Past performance is no guarantee of future results.
Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.
This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk, credit risk and inflation risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Credit risk is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.
Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice.
Diversification does not assure a profit or protect against loss in a declining market.
Bond Spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting the yield of one instrument from another.
The Bloomberg U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage backed securities, asset-backed securities and corporate securities, with maturities greater than one year.