Bonds Are Doing Their Job
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It may not feel like it, but bonds are doing their job. In this time of turmoil, U.S. Treasuries and high-quality municipal bonds remain a haven. Although nearly all bond indices are down year-to-date, they are providing important diversification benefits. Even emerging market bonds, which have taken a beating this year, are doing their job in the sense that they represent attractive value at current spreads.
Higher Yields Stalled in Flight to Quality
You could be forgiven for being a bond bear. Nearly all bond indices are in the red this year as investors anticipate the Federal Reserve to make five to seven 0.25% rate hikes in 2022.
Continued strong employment data and persistent inflation have only firmed the Fed’s resolve to raise rates. In the wake of January’s 7.5% annualized CPI print, Fed Chairman Jerome Powell told the House Financial Services Committee, “This is strong, high inflation, and it’s very important that we get on top of it, and that’s exactly what we’re going to do.”
Two-year Treasury yields, which closely track Fed interest-rate policy, have risen from 0.74% at year-end to about 1.65% today. Bond prices fall as rates rise, leaving even short-term bond holders with negative returns.
Ten-year Treasury yields reflect investors’ expectations for longer-term economic growth and inflation. After peaking at 2.05% mid-month, the 10-year Treasury ended February at 1.83%. The catalyst to this reversal in yields was largely a flight to quality in response to Russia’s invasion of Ukraine. The invasion brought with it not only geopolitical uncertainty but also higher oil prices, which tend to drag on economic growth as consumers are forced to pull back on other forms of spending.
Investors have been lowering 2022 growth forecasts considering these developments, and the narrowing spread between the two-year Treasury yield and the 10-year Treasury yield suggests investors don’t believe the Fed can raise rates aggressively without substantially curtailing economic growth. We’ll be watching this relationship closely for clues to the resilience of the recovery and the path of interest rates.
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