2022 has been an extremely volatile year across all asset classes. Whether it was Stocks, Bonds, Currencies, or Crypto you have likely seen headlines throughout the year containing words such as “Unprecedented”, “Largest Ever”, and “Not seen in XX years”. While some of these headlines are just clickbait, we have had a very rare occurrence take place – both stocks and bonds are meaningfully down together. Since 1928, on an annual basis, this is only the 4th time it has taken place!
In fact, this year’s bond rout is one of the worst on record. While shorter duration bond ETF (SHY) has outperformed the SP500, you can see below longer duration bonds (EDV) have gotten crushed, down over 40%!
These government bonds have traditionally been seen as “Safe Assets”, a place investors will flee to in the event a recession is on the horizon. Typically, in a balanced portfolio, holding bonds have given investors comfort in the event their stocks were to significantly fall, they would see price appreciation in their bond holdings as investors ran to safety. Broadly speaking this diversification approach has worked for the past 100 years, barring these 4 occurrences. Why not now? With inflation being higher and stickier than the Federal Reserve (Fed) expected, they have been forced to raise interest rates in an attempt to curb demand and lower inflation. Bonds are particularly sensitive to these interest rate changes. When the Fed raises interest rates, existing bond prices decline as investors anticipate new bonds coming into the market offering investors a higher yield. These existing bonds see a decline in price in order to make their comparatively lower interest rate payments more appealing to investors. With the sell-off in these “Safe Assets” there has been no place to hide. Cash is king and likely will be until investors feel this interest rate hiking cycle is close to the finish line.
How close are we? The Fed has been very clear they are willing to let the economy feel some pain in order to crack inflation – and both equity and bond markets are reflecting that pain. If or when things get worse, the Fed will ultimately pivot from its current stance giving relief to financial markets globally. We have already begun to see other Central Banks (Bank of England and Bank of Japan) roll out support for their bond markets as problems continue to rise. European Central Bank is likely next to take action with Fed not too far behind. We will be watching the bond markets closely as investors sniff out how close we are to the much-anticipated pivot.