Glimmers of sunlight through the storm clouds

2022 – a dark year for bonds

For government bonds, years like 2022 are rare. To put the year into perspective, if we go back as far as 1977 using the Bloomberg US Aggregate Bond Index, in its 45 years of existence, there have only been five years of negative returns. The most significant annual decline prior to 2022 was in 1994 when the index was down close to 3% (in US dollar terms).

2022 was a standout year (for the wrong reason) - US government bonds were down 17% at their lowest point before recovering to end the year down 13% (in US dollar terms).

Traditionally, multi-asset investors have relied on developed economy government bonds to provide a stable source of return that helps to smoothen their investment journey. Bonds have tended to provide diversification benefits, helping to dampen the negative impact when risk assets like equities sell-off. During 2022, these tendencies were upended, bonds behaved in a similar manner to equities, both falling in tandem.

However, there was one positive for the euro and sterling based investors, favourable currency moves provided some shelter from the storm. The US dollar appreciated by 6 and 11% versus euro and sterling respectively.

Central banks play catch up

To suppress inflation, central banks of many emerging economies began increasing interest rates in 2021. Central banks of developed economies on the other hand, albeit less accustomed to dealing with inflation outbreaks, were slower out of the blocks. Inflation gained a foothold, leaving these central banks to play catch up.

Jerome Powell, Federal Reserve (Fed) Chair, admitted in November 2021 that the characterisation of inflation as ‘transitory’ had been an mistake. Despite this, US interest rates did not increase until March 2022, when US headline and core inflation were 8.5% and 6.5% respectively, close to their peak levels. The ECB (European Central Bank) then joined the global rate hiking cycle in July 2022, at a time when Eurozone headline inflation was already 8.9% and rising.

Falling behind the curve with inflation meant that an aggressive frontloading of interest rate hikes was inevitable. The Fed proceeded to deliver 4.25% of rate increases in just 10 months – the fastest pace of any US rate hiking cycle in the past thirty years.

The aggressive approach by central banks, along with a low level of starting yield in 2022, resulted in the dramatic sell-off in developed economy government bonds. The US 10-year Treasury yield moved from 1.5% at the beginning of the year, before reaching a peak of 4.2% in October. While the yield on the Germany 10-year Bund started the year in negative territory (-0.2%), before reaching a high of 2.6% in December.

The low level of yield at the start of 2022 meant that the income portion of the overall return for bonds was overshadowed by the extreme negative price change as yields increased over the course of the year (bond yields and prices move in opposite directions).

Davy positioning

For the first time in several years, government bonds have become a more attractive investment prospect. In Davy discretionary model portfolios, the long standing underweight position to fixed income duration was reduced in the fourth quarter of last year in response to the significant move higher in yields.

Following the change to the fixed income allocation, bond yields then softened late last year when expectations grew for a pause in Fed rate hikes. Following the softening we decided not to proceed with the additional duration to our discretionary model portfolios. We continue to monitor developments closely for an opportunity to add long duration bonds if yields return to a more attractive entry point.

Uncertainties do remain however. The level and persistence of terminal policy rates will depend on inflation developments in coming quarters. The Fed are determined to avoid a 1970s style policy error – cutting rates too early and allowing inflation to re-accelerate. There is a chance that interest rates may be kept higher for longer or increased further than the market is currently anticipating. Having said that, we do not expect a repeat of the dark year that was 2022.