Stock and bond markets across the globe have been quite active since the beginning of 2022, working to process the everchanging events unfolding in real time. The war raging in Ukraine and the ripple effects across the world on global trade and political relations, continued rates of inflation in the U.S. not seen in decades, a strong, yet complex job market affecting workers and employers in differing ways, and the interconnectedness of all of these and the way in which the Federal Reserve Bank must balance its dual mandate of managing inflation and working toward maximum employment have made for a turbulent period for investors.
Historically Low Bond Returns
Although volatility, both up and down, has been experienced in all facets of capital markets, much of the attention surrounding this volatility has not been focused on equity markets, as we’ve grown to expect, but rather on the bond market and the ongoing upward shift in interest rates. In fact, the broad-based Bloomberg U.S. Aggregate Bond Index had its third worst calendar quarter performance in its history.1 Though such an extreme statement has the potential to elicit a reaction of fear, context is key. The reality is that this near worst-case scenario amounted to a return of -5.93% for the quarter.2 In contrast, the return of the S&P 500 for the quarter was just the 65th lowest and narrowly outpaced that of the broad bond market with a return of -4.60%.3 For comparison’s sake, the third worst return for the S&P 500 goes back the Great Depression and caused losses of nearly 28% in just three months.4 A bear market in bonds is a very different thing than for stocks.
The Cause for Lower Bond Returns
As we shared in a video earlier in the year, interest rates for securities issued by the U.S. Treasury, from 30-day T-bills to 30-year T-bonds, have increased quite dramatically from their pandemic lows.5 As a reminder, interest rates and the price of bonds have an inverse relationship, meaning when one goes up, the other goes down. So, although in the long term these movements are positive for investors who are looking for returns that may outpace inflation from their fixed-income investments, the short-term cost is a reduction in the value of their current holdings.
It’s also important to note that unlike with stocks, there is strong evidence that as a bond investor, owning the entire market all of the time may not be in your best interest. Because the length of time that a bond has until it matures and pays an investor back their principal typically is directly related to the amount of the change caused by movements in interest rates, longer-term bonds have suffered significantly more than shorter-term bonds.
How We’re Managing Your Portfolio
Although we can’t predict the future for stocks or bonds with any reliability (and we don’t think anyone else can consistently either), the shape of the yield curve does inform how we may be best positioned in our allocations for various market conditions. For example, when bonds with shorter dated maturities have yields similar to those of longer-term bonds, we avoid long-term bonds. We can see the impact this has in our portfolios by looking at funds that represent different types of bonds. On the short end of the curve, the Vanguard Short-Term Bond ETF, which is a core holding in many of our balanced portfolios and likely is included in your portfolio, was down 3.42% for the quarter.5 Certainly not great, but compared to the Vanguard Long-Term Treasury Bond ETF, which was down 10.20%, it provided relative stability.6 Additionally, in cases where a retirement plan may offer a unique investment option called a stable value fund or a liquid fixed annuity, many fixed income returns in our portfolios were positive. Positioning portfolios appropriately based on relative opportunities is always a part of our process and commitment to clients.
What To Make of an Inverted Yield Curve
As of now, rates on bonds continue to fluctuate quite significantly on a daily basis, as markets work to price in the impact of global shifts and uncertain upcoming actions by the Fed. In fact, just recently the shape of the yield curve changed from flat to inverted, meaning that the short-term two-year T-note had a yield that was higher than the benchmark 10-year T-note.7 This is unusual, as long-term bonds are paying investors less than shorter-term bonds while continuing to carry significantly higher risks. In this type of environment, we continue to advise staying on the short end of the curve.
For some, the concerns about an inverted yield curve go beyond their bond portfolio and into the broader economy. Inverted curves are viewed by many as being predictive of a recession in the next year or two. And although this relationship has held true the past few times this has happened, there’s no way to discern if there’s any causal relationship. For example, the last time the two-year Treasury paid more than the 10-year was in the latter part of 2019.8 And although we did have a recession as a result of the economic impacts of COVID-19 in early 2020, would anyone say that they were related? Perhaps if there had not been a pandemic there still would have been a recession, but perhaps not. The reality with this and other “economic tea leaves” is that although one may have followed the other in the past, there’s not statistically significant support to say that they’ll do so in the future.
Let’s pretend that an inverted curve was a perfect predictor of future recessions within the next 24 months. What would investors do about it? In most cases people will say they’ll be better off selling their stocks and staying in cash until the coast is clear. But would they? Fortunately for us, we don’t have to speculate. Two leaders of financial economics, Eugene Fama and Ken French, studied this exact strategy in a paper titled, Inverted Yield Curve and Expected Stock Returns. Their conclusion as to whether using yield curve shapes to predict future stock returns as a go to cash signal? “We find no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three, and five years.” In fact, such a strategy underperformed a buy-and-hold stock portfolio in all 24 instances in the U.S. and the majority of those in international markets.9
Balance Is Key
Our experience in the first quarter shows that for most individuals looking for an all-weather portfolio—one that can sustain them in ever changing markets—having balance is key. A portfolio that focuses too much on holding just one type of asset or another may be at the top today, but the bottom tomorrow. Designing and managing a just-right-for-you portfolio that matches your goals and considers the volatility of our complex world is an honor we are delighted to hold.
- Dimensional Returns Web, for the time periods of January 1, 2022–March 31, 2022 and October 1, 1929–December 31, 1929.
- Dimensional Returns Web, for the time periods of January 1, 2022–March 31, 2022 and October 1, 1929–December 31, 1929.
- Dimensional Returns Web, for the time periods of January 1, 2022–March 31, 2022 and October 1, 1929–December 31, 1929.
- Dimensional Returns Web, for the time periods of January 1, 2022–March 31, 2022 and October 1, 1929–December 31, 1929.
- Morningstar Direct
- Morningstar Direct
- As of April 4, 2022. Daily Treasury Par Yield Curve Rates. U.S. Department of the Treasury. https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2022
- August 26–Sept 3, 2019. Daily Treasury Par Yield Curve Rates. U.S. Department of the Treasury. https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2019
- Fama, Eugene and French, Kenneth. (2019) Inverted Yield Curve and Expected Stock Returns.
NOTE: The information provided in this article is intended for clients of Carlson Capital Management. We recommend that individuals consult with a professional adviser familiar with their particular situation for advice concerning specific investment, accounting, tax, and legal matters before taking any action.
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