Bond Market Carnage
2022 is off to a very rough start for the bond market. Through May 5th, the Bloomberg Global-Aggregate Total Return Index, which represents a diversified pool of global bonds, is down over 12% - a loss of over $6 trillion in value. Certain sectors of the bond market have fared much worse (e.g., the long-term US Treasury bond ETF (“TLT”) is down over 23%).
The chart below comes courtesy of Bianco Research, one of the world’s leading fixed-income experts. The chart shows the year-to-date performance of the Bloomberg Global-Aggregate Total Return Index for every year going back to 1980. Each line represents the price change of the index for a given year. As one can see, the 2022 year-to-date return (in bold) is the worst in the last 40 years.
So, what is causing this drop and what does the future hold for the bond market? To understand why the bond market is falling, one must first understand why it mainly rose for most of the last 40 years. Bond market performance is comprised of two factors (the fixed-income payment that the bonds provide and the price change of the underlying bond itself). If we look at the return attribution of bond market performance over the last 40 years, we learn that a large portion of the market performance came from capital appreciation of the bonds rather than just from the income payments. This occurred because global interest rates were generally falling over this period and bond prices tend to move inversely with prevailing interest rates. For example, look at the chart below which shows the U.S. Federal Funds Rate (i.e., the rate at which banks lend money to each other for overnight reserves). This rate is set by the U.S. Federal Reserve Bank (the “Fed”) and generally drives other interest rates. One can easily see that we’ve been on a 40-year downtrend since peaking in the early 1980s.
So, the lesson here is the Fed (and other central banks) have a massive impact on the bond market through movements in the Federal Funds Rate. So, a falling Federal Funds Rate generally means rising bond prices.
As we look at the recent performance, the market seems to have finally internalized that rates are now heading up after spending much of the last decade at 0%. Inflation has become a very real concern for governments and central banks are aggressively raising rates to combat it. The Fed increased the Federal Funds rate by 50 basis points during its May meeting and the market expects further increases ahead. In fact, based on the pricing of certain futures contracts we can infer that market participants are now expecting the Federal Funds Rate to end the year at over 3% - meaning another 2.25%+ in additional increases are expected.
So, the key question is, “Where does the bond market go from here?” As in the past, we would say the Fed will play a major role. The bond market will be looking to assess any changes from the current expected pace of increases. An acceleration in the raising of the Federal Funds Rate relative to expectations and/or a higher long-term target before it stabilizes will adversely affect bond prices. If the Fed pivots to smaller increases or a lower long-term target, we will likely see a slowing or reversal of the current bond price depreciation. It’s also noteworthy that the Fed has discontinued its bond buying program that was instituted to provide market liquidity. In other words, a very large bond buyer from the last few years (i.e., the Fed) is exiting the bond market which is likely to adversely impact bond prices.
Using history as our guide, the Fed generally increases until something bad happens (i.e., a slowdown in the economy, a spike in unemployment, or deflation) and then they tend to reverse course. So, keeping an eye on these metrics may give you clue to Fed actions. Also, many believe there is now a “Fed Put” on the stock market meaning the Fed would slow down after a certain percentage drop in the overall stock market. Only time will tell on that front.