December 13, 2022 | By Hank Cunningham
There is a growing, almost unanimous, consensus that inflation has peaked and will fall rapidly, leading to more declines in bond yields. The lagged effect of this year’s seven increases in central bank lending rates has caused economic activity to ebb. Whether economies fall into recession is the big question and the answer is not yet clear.
It has been a grueling year for fixed income investors, one of the worst ever for performance. Next year should witness a return to positive performance, perhaps in the range of 4% to 6%. This outlook presumes a peaking in the central bank’s tightening, and steady progress on the inflation front. To be sure, inflation remains in the forefront; however, wage increases could limit its improvement.
Central bank rates will stay elevated with no easing likely in all of 2023. The yield curve will remain inverted for the foreseeable future. In the meantime, fixed income investors can earn 5% or more on short-duration bonds, thus producing positive returns with minimal risk to principal.
In summary, global credit markets are discounting the next rounds of interest rate hikes, which removes the surprise factor and should result in few knee-jerk reactions. It is possible that several central banks reduce their bloated balance sheets via bond sales. The corporate bond market is a good place to look for signals that monetary tightening is beginning to affect credit quality.