Most experts agree that 2022 was a horrific year in the bond market. Last year, the Bloomberg Aggregate Bond Index (AGG) lost roughly 16%, which was the most since the 2008-2009 Financial Crisis.
However, on the flip side, the potential now exists for a rebound in the sector—a setup that often draws contrarian investors and traders like moths to a flame.
So what went wrong last year?
In 2022, the U.S. Federal Reserve raised benchmark interest rates at the fastest pace since the 1970s. As most market participants are well aware, interest rates share a strong inverse correlation with bond prices. That means when interest rates go up, bond prices go down, and vice versa.
The steady rise in interest rates during 2022 put constant pressure on bond prices. The end result was a steep drop in bond prices across the board.
What’s compelling about last year’s action is that it sets the stage for a rebound in the bond market during 2023 and likely beyond. In fact, there are three market factors that could contribute to a rally in bonds this year, including a Fed pivot, a potential flight to safety, and higher absolute rates of return.
That means a product like the iShares 20 Plus Year Treasury Bond ETF (TLT), which is already up nearly 6% year-to-date, might have more room to run.
To learn more about the bond market’s strong potential in 2023, watch this episode of Options Jive on the tastylive financial network.
The Federal Reserve is expected to pivot in 2023
The Fed will meet for the first time in 2023 on Jan. 31, and the Fed’s decision on interest rates will be announced at 1 p.m. CST on Feb. 1.
In Dec., the Fed raised benchmark rates by half a percentage point, bringing the target range to 4.25%-4.5%. That’s the highest level observed in the federal funds rate since 2007.
Current projections suggest the Fed will raise benchmark rates above 5% during 2023, which means another hike may be forthcoming on Feb. 1.
However, most industry experts agree that the Fed is in the late innings of the current rate-hike cycle. That means a Fed pivot could develop at some point in H1 2023. In this context, pivot refers to a change in the Fed’s approach from hawkish to more dovish.
Current projections suggest that the Fed will stop hiking rates once the benchmark fed funds rate reaches roughly 5.25%. After that, the Fed will likely wait and see how the economy performs with rates at that level.
That means the end of the current rate-hike cycle is effectively on the horizon, which in turn means bullish sentiment could take hold in the bond market, and even persist in 2023. As highlighted below, the bond market has already started 2023 on strong footing.
Potential flight to safety in 2023?
Bonds are unique because their prices are sensitive to a variety of market factors.
As stated previously, bond prices are extremely sensitive to changes in interest rates—as interest rates increase, bond prices tend to fall, and vice versa. However, bond prices can also fluctuate due to their perceived safety in the financial markets, especially government bonds.
For example, when fear grips the markets, investors and traders often pile into the relative safety of government bonds to shield capital from a potential correction in the stock or commodities markets. And that type of demand in the market typically results in higher prices.
A clear example of a mass flight to safety was observed during the onset of the COVID-19 pandemic, when market participants stampeded into the bond market—a situation that pushed the 10-year Treasury yield to its lowest-ever level (0.54%).
There’s no guarantee that a market panic develops in 2023, which would trigger the same level of demand for bonds as observed in early 2020.
However, anxieties over a global recession have been growing in recent months, and those concerns have contributed to a small rebound in bond prices as investors and traders have slowly increased their capital allocation toward bonds.
For example, the U.S. 10-year Treasury yield has fallen to 3.46%, from 3.83% at the end of 2022, reflecting an opposite-but-equal pop in bond prices. That situation helps explain why the aforementioned TLT is already up nearly 6% on the year.
As such, the risk of a recession—or some other systematic risk to the financial markets—could provide further support to the bond market, resulting in even higher prices.
The impact of higher absolute interest rates
Beyond a Fed pivot and potential trepidation in the global financial markets, the bond market could also benefit from higher absolute rates in 2023.
Generally speaking, higher absolute rates on fixed income (bonds) usually results in stronger demand from investors and traders. For example, few investors would be interested in a bond that pays 1%, as compared to one that pays 4%—all else being equal.
At present, the current yield on the 2-year U.S. Treasury bond is 4.12%, which is clearly more desirable than a year ago when it was closer to 1%.
When considering the possibility of a forthcoming U.S. economic recession, and its potential impact on the stock market, it’s easier to see why a risk-free return on 4% might draw more investor interest in 2023, as compared to recent years.
The presence of higher absolute rates could therefore be a driver of stronger demand in the bond market this year, which in the end could also help elevate prices.
That sentiment was echoed recently by Meera Pandit, a global market strategist for JPMorgan Asset Management, who recently told Bloomberg Television, “The attractiveness of bonds going into the rest of 2023 has surged.”
To learn more about the bond market’s strong potential in 2023, check out this episode of Options Jive on the tastylive financial network. To follow everything moving the markets in 2023, monitor tastylive, weekdays from 7 a.m. to 4 p.m. CDT.
Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastylive or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to email@example.com.