Will bonds continue to suffer in Q2 amid Fed rate hikes?

Bond prices (like equities) have declined appreciably in 2022 so far in response to sharp increases in interest rates as central banks, particularly the U.S. Federal Reserve Bank (Fed), deploy “artillery” to wage war against inflation which has been exacerbated by the ongoing Russia-Ukraine conflict. Already in the four completed months of 2022, the benchmark U.S. 10-year treasury yield, for instance, has more than doubled its increase recorded in 2021. It has soared circa 140 basis points (100 basis points is equal to 1 percentage point or 1%) year-to-date versus an incline of 60bps in 2021. The bulk of this year’s increase in bond yields occurred in the just concluded first quarter (Q1). So, naturally the question has arisen - are yields likely to continue to rise at a similar pace in Q2 and indeed for the rest of the year thus extending the weakness in bond performances? 

It is possible that the year-to-date pace continues or even accelerates in Q2, but this is unlikely to happen. Two points are worthy of consideration. The first is that much of the impact on bond yields from the Fed raising interest rates has already been priced in, thereby leaving modest room for further upside in rates from here. The market for instance is currently expecting about 250bps of Fed rate hikes in 2022. The 2-year yield, which is more sensitive to Fed hiking than longer-term rates, has already moved up by 190bps suggesting a maximum potential further upside of 60bps for the rest of the year or on average 20bps increase per quarter. It is however worth noting that as the Fed raises its policy rate, it doesn't necessarily translate into a commensurate upward movement in short-term bond yields. Furthermore, on the longer end, rates tend to reflect the outlook for inflation and economic growth. Both are expected to wane as the Fed hikes and should therefore reduce the upward impetus on long-term rates. Nonetheless, there is scope for 10-year rates to move modestly higher, aided by a reduction in the Fed's balance sheet, which will remove some downward pressure on longer-term rates that is usually occasioned by cooler inflation and slower economic growth.

The second consideration is that bond returns have typically rebounded after bad quarters. As illustrations, the 10-year U.S. treasury yield rose 33bps in Q1 2018 and subsequently slowed its rise in Q2 to a modest 12bps. More recently, in 2021 the 10-year rate climbed 83bps in Q1 but then fell by 27bps in the following quarter. Recall that bond prices fall when yields rise and vice versa. So, from an historical perspective, bonds should fare better in Q2 than in Q1. And although past performance does not guarantee future outcome the trend is likely to continue unless the Fed again ratchets up its policy tightening.

In summary, bond performance is expected to improve at least in Q2; while bond yields should only move significantly higher if the Fed is expected to be even more aggressive in its tightening policy than currently envisioned. It is also worth remembering that bonds play an invaluable role in portfolios as they offer periodic income and facilitate portfolio diversification given the general negative correlation between bonds and equities over time.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm