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Bonds are Back: The 3 Fs (Pressure Points) and Moderating Inflation

Tony Crescenzi and host John Nersesian discuss the 3 F’s (The Fed, Fiscal Policy, and Financial Conditions) that may reduce inflation rate. Learn why today’s higher starting yields across fixed income sectors – combined with potentially lower volatility – help set the stage for bond investors to pursue alpha in 2023.

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Text on screen: PIMCO EDUCATION Title Bond are Back: The 3 Fs (Pressure Points) and Moderating Inflation with John Nersesian and Tony Cresenczi (3 minutes)

John Nersesian: So investors often allocate to fixed income as a way of sidestepping or avoiding volatility, right, that they might be experiencing in other asset classes.

Text on screen: John Nersesian, Head of Advisor Education

Last year unfortunately we saw significant volatility in fixed income. Tony, you're expecting there to be less volatility this year. Explain why.

Text on screen: Tony Crescenzi, Portfolio Manager, Market Strategist

Tony Crescenzi: Well first, 2022 in the historical context is an anomaly. Remember there were 18 trillion of negative yielding bonds in the world and we simply were moving away from that regime. And the history of interest rates is a lot different. So we've normalized, so to speak. But the main reason to expect lower interest rate volatility in 2023 versus 2022 is because the forecast miss for central bank interest rates is likely to be far lower.

So for example, for the Federal Reserve, market participants along with the Fed itself were projecting that the Fed would end its policy rate at around 1 percent at the end of 2022. Of course the result turned out to be almost four points higher than that with markets now priced for 5 percent policy rate. So what are the odds that the markets get it wrong by 4 points again.

We think low, mainly because inflation — the inflation rate seems likely to be moderating based on three pressure points.

Text on screen: TITLE – The three F’s (pressure points):, BULLETS – Fed tightening, Fiscal contraction, Financial conditions

And I call them the three Fs of tightening. Number one, the Fed. Secondly, fiscal, certainly some fiscal contraction occurring now, or I should say much lower stimulus than we had certainly post-pandemic. And third, financial conditions, tighter because of higher interest rates, lower stock prices, wider credit spreads.

Those three pressure points should reduce the inflation rate, along with of course some post-pandemic related supply chain moderation. And thereby enable the Federal Reserve and other central banks to take a break.

Now what if we're all wrong about interest rates again, perhaps it'll be a half point or a full point, where the policy rate ends at 6. It's difficult for us to imagine between the Fed fund's rate change and quantitative tightening by the way, meaning the Fed reducing its balance sheet by shedding the securities it bought during the pandemic, all should work the magic so to speak.

And so we'd say the expression, don't fight the Fed today, has a different meaning from a year ago, don't fight the Fed a year ago meant run for the exits. This year it means believing in its long standing ability to control the inflation rate and to control interest rate volatility in the long run.

John Nersesian: Love it. So let me get this straight. Higher starting yields, lower volatility, that really supports the case for why bonds today.

Tony Crescenzi: Especially because it means therefore that today's yields,

FULL PAGE GRAPHIC: TITLE – Today’s yields are at a much stronger starting point. The bar chart shows yield to worst (YTW) for various fixed income asset classes. YTM is the estimated lowest potential yield that can be received on a bond without the issuer defaulting. The solid-colored bars show YTW as of December 31, 2022 at much higher starting points compared to December 31, 2021 across fixed income asset classes, namely core bonds, investment grade credit, high yield credit, emerging market bonds, municipal bonds, and high yield municipal bonds. The yields for most fixed income asset classes more than doubled in 2022 from 2021 levels.

which are above the 20 year average and roughly in line to slightly above the 30 year average for bond yields based on major indices, look relatively attractive compared to historical volatility.

And we're going to use historical volatility as our base case for the years ahead.

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Disclosure


Past performance is not a guarantee or a reliable indicator of future results.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

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