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Bonds Have Been in Rally Mode. Don’t Get Excited—The Fed Has More Work to Do.

Fed Chairman Jerome Powell will address the Economic Club on Tuesday, when he is expected to take a hawkish tone.

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Al Drago/Bloomberg

Bonds got off to a great start this year but there may be challenges ahead as recent data suggest the Federal Reserve has more work to do.

There were 517,000 jobs added to the economy in January, more than double the level recorded in December and nearly triple the number forecast by economists. The white-hot labor market means that, while the Fed’s interest rate hikes have shown some success in cooling inflation, the hikes have yet to lead to a meaningful drop in consumer demand as companies still feel the need to add labor—particularly in service-oriented parts of the economy.

That’s great news for workers but it also means that rather than the Fed nearing a soft landing after years of loose monetary policy it will have to continue to aggressively tighten to keep inflation under control. For bond investors bruised after a challenging 2022, that could spell some trouble over the next few months.

“With the risk of a no-landing scenario rising, the Fed will remain hawkish for longer, and that will keep credit markets volatile over the coming quarters,” Torsten Slok, chief economist at Apollo Global Management, wrote in a recent note.

Using data dating back to 1997, Slok determined that credit spreads aren’t yet pricing in a recession as the spread between investment-grade and high-yield bonds is consistent with historical averages and well-below levels recorded during downturns such as the onset of the coronavirus pandemic or the 2008-09 financial crisis.

As for the rally in bonds earlier this year, Slok says investors were likely assuming a recession would hit soon so they entered 2023 underweight in stocks and bonds. When economic conditions appeared more favorable, investors rushed to get back into the market.

This isn’t to say the Fed’s tightening hasn’t had any effect on the economy. The areas most affected have been those that are most sensitive to rising rates such as housing and auto loans. But roughly a year into the Fed’s rate-hiking cycle, areas that were thought to feel the effects of tighter monetary policy on a lag still have yet to show signs of weakness.

“It’s really unusual for the lag effects of monetary policy that even now, almost a year after the Fed started raising rates, that the economy is still producing more than 500,000 jobs a month,” Slok told Barron’s. “That is eye popping from a monetary policy perspective because that means that the lag effects are clearly not kicking in on the broader economy.”

And that may mean, even after slowing the pace of rate hikes, the Fed may have to continue to be aggressive until it’s sure its job is done. 

“The bottom line is that both for credit and for equities, that maybe we do need to wait a while longer and maybe we do need even higher levels of yields before the service sector starts responding,” Slok said.

Slok says investors should pay close attention to Fed Chairman Jerome Powell’s talk at the Economic Club on Tuesday where he expects Powell to take a “hawkish” tone. Beyond that, Slok will be looking at consumer price index data released next week to get a sense of how quickly inflation is coming down.


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