January 12, 2023 | By Hank Cunningham
The predominant belief among market participants is that inflation will decelerate rapidly, the Fed will stop hiking rates and there is a recession coming. Thus far, inflation has eased for three straight months, with the services component of CPI being the biggest contributor to still elevated inflation. For its part, the Fed, via different pronouncements, indicated that more hikes are to come, with the Fed Funds Rate going to at least 5%. It is likely, however, that hikes of only 25 basis points are in the cards. As to the recession, weakness is spreading in the economy, beyond what we’re seeing in housing. Manufacturing is weak and consumer confidence is sliding. Thus far, however, the employment market remains taut, with continued growth in non-farm payrolls, a lower unemployment rate and solid wage gains.
Last year was grueling for fixed income investors, the worst ever for performance. The coming year should witness a return to positive performance, perhaps in the range of 4% to 7%. This outlook is based on a peaking in central bank tightening plus steady improvement on the inflation front. To be sure, inflation remains in the forefront, and wage increases could limit 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 will be able to earn 5% plus on short-duration bonds, thus producing positive returns with minimal risk to principal.
There are obstacles to this consensus forecast. Wage increases may continue to act as a floor on inflation. Fiscal stimulus from the U.S. will produce a total of $2 trillion dollars to be borrowed from the bond market. A third possibility is that energy inflation could surprise on the upside.
In summary, there will be more chapters in the bond market drama and we expect a wide trading range of 3.25% to 4.25% on the U.S 10-year Treasury bond.