The calm before the storm
2021 was a year of relief where the world exhaled and began breathing in fresh air after the pandemonium that raged in 2019 and the uncertainty that wrote off 2020.
Exuberance raged in the stock markets, and the bond markets saw a relatively flat year. Inflation in the year’s first quarter was unnotable, mirroring the averages of the past decade-plus since the Great Recession.
As 2021 unfolded, inflation rapidly escalated to 7% by year-end, and the stock and bond markets mostly shrugged off the escalating pace. However, 2022 would not be as forgiving.
Inflation crests
Inflation is a tricky thing for economies. A lack of inflation suggests that your economy is struggling with a lack of investment and employment. At the same time, too much inflation likely means that demand is outpacing supply and can cause numerous issues.
When the Coronavirus, known as COVID-19, wreaked social mayhem in 2019 and 2020, the US government and Federal Reserve (also known as the Fed) responded by flooding the markets with money to prevent economic calamity. After all, businesses closed for extended periods, many workers lost their incomes, and consumers stopped spending.
The government and Fed took these offensive actions to stave off a significant recession, including business PPP loans, IRS pandemic relief checks, and quantitative easing. Over $757 billion in business paycheck protection loans received forgiveness (meaning they didn’t require repayment), $803 billion in IRS pandemic relief checks were issued to taxpayers, and the Federal Reserve nearly doubled its balance sheet (freeing up institutional liquidity) between 2019 and 2021.
The result is that the US money supply rapidly increased, and as COVID-19 became more manageable, consumer and business spending increased dramatically. With increased spending and a supply chain that remained disrupted from the pandemic, demand outpaced supply, leading to a rapid increase in inflation, which peaked at over 9% by 2022.
Changing tides
Despite inflation swelling quickly, the Federal Reserve stayed hesitant in 2021 and kept interest rates near zero yearlong. But, in 2022, the Fed dramatically raised its target for the Fed Funds Rate, which is the rate banks charge each other.
While I could devote a post to the Fed Funds Rate, that is for another day. As a quick synopsis, the Fed Funds Rate is how much banks lend money to each other for overnight loans to ensure compliance with the number of reserves they must keep on hand. Banks can borrow funds from another institution with an excess if they need more deposits to meet statutory requirements of their assets to liabilities. This rate that banks lend to each other is the Fed Funds Rate.
The Fed doesn’t directly control interest rates. Instead, it sets a target range. Then it partakes in buying and selling activities of various US government securities and other financial instruments to alter the money supply, which in turn causes the Fed Funds Rate to pivot.
In 2022, the Fed raised its target seven times and steered the Fed Funds Rate to close out the year at 4.33%. These changes were the most dramatic raises the Fed has taken in nearly forty years and occurred to curtail inflation.
Calamity floods the markets
If 2021 was a neutral year for the bond markets and great for the stock markets, 2022 saw a rip-tide event wreak havoc. The US bond market saw a 15.5% drop, and the S&P 500 sank by 24%.
The Vanguard Total Bond Market Index Fund saw its worst performance in thirty years, and retirees saw their defensive and offensive positions plunge in unison.
But why did bond prices and funds plunge while interest rates soared? After all, investors received better yields than anything in the past fifteen-plus years.
The answer lies in the Fed’s open market activities, such as the bulk purchasing of various US treasuries.
To quell inflation, the Fed had to decrease the availability of dollars and various dollar-backed government instruments, which in turn raised interest rates. So, it began selling treasuries, amongst other activities, to take money out of the economy. Meanwhile, the US Treasury started issuing new government debt at higher interest rates.
Because of these coordinated efforts by the Fed and the US Treasury, banks became less willing to lend to one another since more and more money was getting locked into government debt. The result increased bank interest rates since they were less inclined to lend to one another, which made consumers, businesses, and institutions less likely to borrow. In theory, slowed lending and less money available means economic activity should slow, resulting in lower demand and waning inflation.
As 2022 ended, the Fed’s efforts succeeded, and inflation began trending downward. However, investor portfolios experienced substantial drops regardless of whether they owned stocks, bonds, or a combination of both.
While it is understandable the stocks would go down as lending dried up, why did bond prices experience their worst plummet in decades? The answer lies in an inverse relationship between bond prices and interest rates.
(Before proceeding, I will note that my discussion above simplifies and abbreviates what the Fed and the Treasury did, which is far more complex than this article will allow for discussion. Anyhow, onto interest rate risk!)
Interest rate risk and bond pricing crash course
Bond prices and interest rates for issued bonds have an inverse relationship, similar to how a seesaw works on a playground.
When a bond is first released, the issuer collects lender deposits that it will use to fund its needs. The depositors usually receive semi-annual interest payments set by the bond’s governing charter. For US treasuries, these interest rates are set by the US Department of the Treasury and vary based on the length of the issued debt.
The amount a lender receives when the bond matures and requires the issuer (i.e., borrower) to pay them back is known as the par or face value. One of the most common par values is $1,000.
However, a lender may decide later that they do not want to hold onto their bond investments until they mature due to liquidity needs or other reasons. After all, bonds often have maturities that range from 10 to 20 years. In a situation like this, a bondholder will resell their bond on the secondary market.
When a bond resells, its price is adjusted up or down to match the prevailing interest rates for that type of security. Bonds issued at a 2% interest rate and a $1,000 par value will go down in price when rates are now 4%. They decrease in value because a buyer will receive the 2% interest rate from the borrower until maturity, plus the remaining 2% through bond price appreciation at maturity through the par value payment.
The amount a bond price goes down during a period of rising rates varies based on how long that bond has until maturity and the issuer’s creditworthiness. Bond prices are more sensitive for maturities that are farther out and generally move more dramatically due to more of the bond’s interest value coming from price appreciation at redemption.
Thus, when the Fed began quantitative easing and other actions to raise interest rates, existing bonds dropped in price (known as their current value) while their effective interest rates increased.
This risk of rising rates and dropping bond prices is known as interest rate risk, and 2022 was the year the risk became a reality that many investors had never seen.
While most individual investors hold bonds through bond funds, they still experience interest rate risk since the value of a bond fund (i.e., NAV price) is determined by the value of the underlying bonds. Thus, the Vanguard Total Bond Market Index Fund saw its worst performance in thirty years.
What does 2023 hold?
We have now come full circle and understand the lead-up to the rise in interest rates and how they directly laid ruin to the bond market in 2022. Therefore, it is time to forecast what 2023 holds for investors and the broader bond market.
Based on the trend from June through December of 2022, inflation is on course for a continued downward trend, barring nothing unexpected.
As headwinds changed in 2022, consumer spending has stalled, and businesses have done massive layoffs in the tech sector. The US economy as a whole has slowed, which was the Fed’s hope, and many analysts forecast only two additional rate increases this year, which would bring interest rates over 5%.
Bond prices may still go down depending on the extent of Fed rate increases this year, assuming they do take place (update: they raised rates 2/1/23), but the severity of these decreases will likely be trivial compared to 2022.
While my assumptions and predictions seem logical to me, they remain guesses. Do you think the Fed has moved swiftly enough to curb inflation and that it will continue downward? I would love to hear your thoughts regarding inflation and the bond market in 2022 through the comments section below.
As always, have a great day!
Update: As of 3/16/23 the future of Federal Reserve rate increases seem unknown given the mass panic in the banking industry from the collapse of Silicon Valley Bank. While it remains likely they will raise rates, the developments of regional banks struggling may change the narrative.