Portfolio Construction

How to use bonds to seek balance as Fed hikes wind down

When stocks zig, bonds are supposed to zag. That time-honored relationship has broken down over the past few years, but there are encouraging signs of its eventual return.

 

There’s no doubt that it’s been a challenging environment for fixed income. Losses in 2022 were particularly steep. It marked the first year in decades that bonds fell alongside stocks. Rapid rate increases by the U.S. Federal Reserve, against a backdrop of some of the highest inflation rates the U.S. economy has experienced in more than 40 years, caused massive upheaval. A look at the correlation between stocks and bonds during equity correction periods since 2010 shows just how unusual a period it was.

Unlike other recent equity corrections, bonds buckled alongside equities in 2022

Source: Morningstar. As of October 31, 2023. Correlation is a statistic that measures the degree to which two variables move in relation to each other; a positive correlation implies that they move together in the same direction while a negative correlation implies that they move in opposite directions. Correlation figures based on returns data for the S&P 500 Index versus the Bloomberg U.S. Aggregate Index. Correlation shown for the eight equity market correction periods since 2010. Corrections are based on price declines of 10% or more (without dividends reinvested) in the unmanaged S&P 500 with at least 75% recovery. Dates for correction periods are as follows: Flash crash, April 2010 to July 2010. U.S. debt downgrade: April 2011 to October 2011. China slowdown: May 2015 to August 2015. Oil price shock: November 2015 to February 2016. U.S. inflation/rate scare: January 2018 to February 2018. Global selloff: September 2018 to December 2018. COVID-19 pandemic: February 2020 to March 2020. Historic inflation and rate hikes: January 2022 to October 2022. Past results are not predictive of results in future periods.

But as those rate hikes recede into the rearview mirror and markets increase their focus on the growth backdrop, fixed income may resume its role as a ballast in portfolios. In addition, higher starting yields mean higher return potential for bonds.

 

“This Fed hiking cycle has been the quickest that we've seen in decades, and it’s likely we’ll see interest rate sensitive segments of the economy soon experience challenges as a result,” says Chitrang Purani, fixed income portfolio manager for CGCB — Capital Group Core Bond ETF and American Balanced Fund®. “Economic weakening should generally be positive for bonds, both from the standpoint of absolute returns and diversification from equities.”

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What went wrong?

 

The large increase in inflation and inflation expectations during 2022 drove a complete shift in expectations for Fed policy — both on the part of monetary policymakers and investors. In 2023, the year started off with optimism for bond returns as investors eyed relatively high starting yields. Yet the Bloomberg U.S. Aggregate Index has struggled to post gains this year as well, returning 0.40% through November 14.

 

The Fed’s actions have continued to loom large, as it raised rates by a total of 100 basis points this year — a slowdown from a 425-basis-point increase in 2022, but still higher than the Fed and markets expected coming into 2023. Although headline inflation has fallen dramatically from a peak of 9.1% in June 2022, it remains elevated at 3.2% as of October. Meanwhile, a much more resilient U.S. economy has led to continued shifts in expectations for not just the federal funds rate but interest rates across the maturity spectrum. A robust labor market, high pandemic-era savings and government stimulus are among the factors behind the economy’s resilience.

Resilient growth and still elevated inflation have adjusted the Fed’s rate expectations

Source: Federal Reserve. As of November 13, 2023. Year-end projections pulled from Federal Open Market Committee statements released on December 14, 2022; March 22, 2023; June 14, 2023; September 20, 2023. Fed funds rate shown is the upper limit of the fed funds rate.