Bond Market Outlook 2022

Bond Outlook 2022

wdt_ID Expectations for the Bond Market in 2022
2 • The Fed will raise interest rates
3 • Inflation will end the year lower than where it begins
4 • Investment-grade-rated corporate bonds offer more reward potential
5 • Bonds will continue to balance risk and provide income to investor portfolios

2021 Bond Market in Review

Before we get to our bond market outlook for 2022, let’s look back on 2021. The year kicked off with a challenging Q1 for bond investors. Bonds battled back with positive results over the remainder of the year—but there wasn’t enough consistency or strength to overcome Q1’s decline. In the end, it was a rare sub-par year—the Bloomberg Aggregate Bond Index (“the Agg”) declined 1.54% in 2021. The Agg has had only had four down years since its 1976 inception (1994, 1999, 2013 and 2021). The worst of those four years was a drop of 2.91% in 1994.

In my opinion, the top story of the year was inflation and how bond investors mostly shrugged it off. If you had told me a year ago that inflation (headline CPI) would be as high as 6.8% and bonds would “only” drop 1.5%, I’d have been incredulous. The problem with hindsight is that it’s always perfect.

Why did some bond investors take inflation in stride in 2021? Because inflation is difficult to predict. Just ask Fed Chair Jerome Powell. Typically, you’d anticipate seeing investors selling bonds in the face of higher inflation. Investors, like policymakers, believed it would be transitory and head lower, which would be supportive of bond prices.

2022 Bond Market Outlook

As the economy works to remove the COVID-19 wrench from its gears, I expect markets to be more volatile overall and economic data will continue to be mixed. Inflation, the enemy of bond investors, will gravitate back toward pre-pandemic levels. I don’t expect it to return to a sub-2% number. But it’s safe to bet that it will reverse momentum and move lower in 2022.

For now, the Fed is moving toward a neutral policy that is neither accommodative nor restrictive. Officials have already accelerated the pace of stimulus removal by winding down bond asset purchases. When that policy concludes, look for at least one interest-rate hike in the first half of 2022. Whether or not there will be multiple rate hikes depends on more than just the economy—it also depends on how other financial markets react, making the Fed’s job all the more difficult.

The shape of the yield curve should continue to flatten with front-end rates rising. This will be welcome news to those of us with cash in the bank or in money market funds currently earning next to nothing. Money market yields will follow in the same direction as the fed funds rate, though perhaps not immediately or in similar magnitude. Short rates are already moving higher in anticipation. Since bottoming last May at 0.015%, the yield on six-month Treasurys has risen to 0.23% as of January 7th. I expect more yield to come, but I don’t forecast money market yields reminiscent of the good old days of 2%+. Still, they will be more rewarding than they are today. Of course, the more the Fed hikes rates, the higher yields will go. For now, rates are starting to move higher, with investors pricing in rate hikes coming sooner than expected.

Treasury bonds, as always, remain the most interest-rate sensitive, so when there are big market-moving headlines—and I expect plenty of those in 2022—traders’ reactions show up in Treasury yields first. At present, Treasury yields remain skimpy. Higher-quality investment-grade-rated corporate bonds offer additional yield to investors.

In my Managed Bond portfolio, we look forward to rates moving higher, and I believe income investors are on the cusp of being rewarded.

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