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HomeMarketU.S. bonds wrap up worst year on record. Here's what may be...

U.S. bonds wrap up worst year on record. Here’s what may be in store for 2023

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U.S. bonds are coming off their worst year in almost a half-century of record-keeping and look poised for a better performance in 2023, according to strategists and asset managers.

Inflation is finally showing demonstrable signs of easing based on November’s and October’s softer-than-expected consumer-index reports — giving Federal Reserve policy makers the chance to switch to a less-aggressive rate hike by February and pause thereafter. Forecasters see the 10-year rate ending next year at around 3.5%, roughly where it stood Wednesday morning, after taking a brief trip toward 4% during the first quarter. This marks an attractive entry point for potential buyers to still come in.

“We think a lot of the repricing of Treasury yields has already taken place, and that this is the best core bonds have looked in over a decade,” said Lawrence Gillum, a Charlotte, North Carolina-based fixed-income strategist for broker-dealer LPL Financial. “We think the prospects for fixed income are pretty attractive at current levels and do think fixed-income returns are going to be better next year.”  

The biggest risk would be if inflation, as measured by the annual headline rate on the consumer price index, doesn’t fall below 4.5% or 5% by mid-2023 versus its most recent level of 7.1% in November — which would force the Fed to push the fed-funds rate up toward 6% from 3.75% to 4% prior to Wednesday’s FOMC decision, Gillum said via phone. Even so, it’s “going to take much higher rates — 7% to 8% in Treasury yields — to generate the same negative performance as this year.”

A toxic combination of persistently hot inflation running around four-decade highs plus a string of Fed rate hikes since March has led to a punishing selloff in Treasurys over much of 2022 — pushing the 10-year yield
TMUBMUSD10Y,
3.490%
up by 1.86 percentage points from its Jan. 3 closing level of 1.63% as of early Wednesday. Yields and prices move in opposite directions, which means 2022’s sharp rise in the 10-year rate has been accompanied by a falling price in the underlying note, hurting existing bondholders.

The Bloomberg Aggregate Bond Index — the broadest domestic measure of the core fixed-income market and which includes Treasurys, agency mortgage-backed securities and investment-grade corporate debt — has declined 11.2% this year through Tuesday. That’s the index’s worst annual showing since 1976, the earliest period that data collecting began.

Bonds were Ground Zero for 2022’s volatility in financial markets, which also produced double-digit losses for the S&P 500 SPX and Nasdaq Composite indexes as investors fretted about the impact of higher interest rates. Treasury yields reflect the outlook for the U.S. economy and Fed interest rates, though the benchmark 10-year yield — which sets a floor on borrowing costs for American companies and households — has surprised many by falling since late October despite expectations that Fed policy makers will still be hiking rates into early next year.

Analysts at BNP Paribas, JPMorgan Chase & Co.
JPM,
+0.54%,
and Deutsche Bank
DB,
-1.33%
are among those who see the benchmark 10-year rate
TMUBMUSD10Y,
3.490%
ending next year at or close to 3.5%, which is in line with the median estimate of 45 forecasters. The forecasts suggest that any rally in bonds next year is likely to be limited and if the U.S. economy does fall into a recession, it should be a shallow one.

2023 year-end forecasts on 10-year rate
Barclays

3.75%, after hitting 4.1% in 1Q

BNP Paribas

3.5% after peaking at 4.3%

BMO Capital Markets

3% after reaching 3.5% in 1Q

Deutsche Bank

3.65% 

JPMorgan Chase

3.4% after hitting 4% in March

The bond sector’s dismal overall performance for 2022 has come as a rude surprise to investors accustomed to the steady performance of fixed income during a 40-year bull-market run. That’s the case despite periodic bouts of buying that emerged in late October, in November, and again on Tuesday following the softer-than-expected CPI print for last month.

A 10-year yield currently around 3.5% is creating opportunities for traditional savers who have stayed away from government bonds “to come back into the market because they’re able to get yields they haven’t seen in more than 10 years,” said Jay Sommariva, managing partner and head of assets management at Pittsburgh-based Fort Pitt Capital Group, which oversees $4.2 billion in assets. “The majority of fixed-income investors we’re buying for are holding until maturity,” he said via phone.

To be sure, forecasting is more art than science, and a lot can happen between now and the end of 2023. At around this same time last year, for example, forecasters had expected the 10-year rate to wind up around 2% by about now — which turned out to be more than a full percentage point below the actual mark.

Collin Martin, a fixed-income strategist for Charles Schwab
SCHW,
+1.04%,
said by email that “we didn’t expect inflation to rise as high as it has and, as a result, hadn’t expected this many Fed rate hikes.” Martin said his firm now sees the 10-year yield ending 2023 between 3% and 3.25%, though it could get there sooner, and should retest the 4.25% level in the near term.

Credit: marketwatch.com

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