Bonds are back
Three things to watch in 2023.
Good riddance to ’22; next year should be better Before talking about 2023, let us acknowledge that 2022 cannot end fast enough—according to Deutsche Bank Research, it was the worst year for government bonds since 1788!1 The year ahead should be better. After soaring across the curve last year, yields are offering attractive income. The 10-year U.S. Treasury yield is near its highest level since 2009! In addition, Treasury yields are more likely to decline than rise over the course of the next 12 months, generating positive price returns as the Fed reaches the end of its most aggressive tightening cycle since the Volcker era. Even if policy rates remain higher for longer and Treasury yields climb a bit more, slowing growth under restrictive Fed policy is unlikely to generate negative returns given the cushion yield levels now provide to help offset price loss.
Still all about inflation We think inflation will keep trending lower in 2023 from its still elevated levels. Declining goods prices, improving supply chains, lower commodity prices, a strong dollar, benign inflation expectations, slowing growth and moderating job growth should drive inflation down. Housing rental costs, which can take up to a year to show up in official inflation statistics, have also started to fall sharply. That said, stubbornly high wage gains, particularly in the labor-intensive service sector, present the greatest risk to disinflation. If labor markets remain tight and inflation remains too high, the Fed merely will get more hawkish, boosting already high odds of recession. Recessions have a strong history of lowering inflation. Thus, a 3-handle on core CPI by year-end seems likely, which would be supportive of bond returns.
Optimistic about munis, too Our more optimistic outlook for fixed-income returns includes the municipal bond market. Like other bond sectors, municipals posted record-setting losses in 2022. But in the current quarter, the moderation in recent inflation data and the highest muni yields in over a decade have supported demand for munis amid low new issuance, producing total returns of more than 4% for the Bloomberg Muni Bond Index. Investors should continue to favor high quality bonds amid elevated recession risks in 2023, which suits the high-quality municipal bond market very well. With AA-rated average credit quality and strong credit fundamentals for most municipal sectors, we think the muni market is well-positioned for favorable returns in the year ahead.
1 “Deutsche Bank Looks Back to 1780s for Parallel to US Bound Rout,” Bloomberg Markets, June 22, 2022