ECONOMIC UPDATE
- Interest rate volatility reached 2022 highs in June as an above-expectations May CPI report drove the first 75 basis point (bp) Fed rate hike since 1994
- Inflation worries morphed into recession worries and potential Fed policy error as the month progressed, leading to a partial retracement in Treasury yields
- Volatility will likely remain a prevalent theme until signs of inflation subsiding emerge
Interest rate volatility has been a dominant theme for fixed income markets in 2022, and June brought the highest levels of volatility yet (see Exhibit 1). Inflation worries at the beginning of the month morphed into recession fears later in the month, fueling another wild ride for Treasury yields. The fireworks began on June 10 with two separate economic releases. First, the May consumer price index (CPI) report was alarming for market participants and central bankers alike, revealing higher than expected readings for headline and core inflation. Later that morning, the University of Michigan consumer sentiment survey set a record low, which is remarkable given that the survey was first initiated in January 1978. In other words, consumer sentiment was lower in June than it was during the Great Recession, 9/11, the dot com crisis, and the 1987 stock market crash, even with unemployment still near record lows. It shows the power of inflation as it relates to consumer psyche, and the report also showed long-term consumer inflation expectations surging 30 bps to 3.3%. The final version of the survey revised inflation expectations down to 3.1%, somewhat easing those initial market worries.
The combination of these reports sparked a violent sell-off in the bond market, with the 2-year Treasury yield rising 54 bps in just two days as the market repriced for 75 bps rate hikes at both the June and July FOMC meetings. The Fed took the market’s queue and raised the fed funds target range by 75 bps on June 15, and the updated summary of economic projections (SEP) revealed a much more hawkish perspective from FOMC participants relative to the previous update in March. The median forecast now shows a 3.4% funds rate by year end and peaking at 3.8% in 2023, more closely aligning with what the bond market had already priced.
The sharp repricing for an even more aggressive rate hike regiment, however, added fuel to growing worries that the major central banks will tip the global economy into recession in combating multi-decade highs in inflation. These concerns, regardless of validity, were enough to whipsaw the 2-year Treasury yield from a 2022 high of 3.45% on June 14 to as low as 2.74% on July 1. We’ve now come to a point where the market is more convinced that the Fed is willing to react aggressively to inflation risks following the 75 bps June hike, and as such, signs of still-elevated inflation have sparked an opposite reaction in Treasuries (i.e., bond yields falling on growing recession fears).
Tighter financial conditions and heightened volatility cemented one of the worst six-month performance periods on record in broad fixed income. As Exhibit 2 notes, the -10.6% return of 1H 2022 was second only to the 6-month period ending Q1 1980, and there is a comfortable gap between the second and third worst periods. The worst 4 periods represented were primarily rates-driven amid similar high-inflation environments, and for portfolios funded with core deposits, much of the negative price performance on the asset side from rising rates can be neutralized by the negative duration of those liabilities from an economic value perspective. However, spread widening and rate volatility have unsurprisingly contributed to negative hedged performance in 2022 as well. For the ICE BofA Broad Market Index, the second quarter was particularly bad, with the index underperforming Treasuries by 1.06%. Hedged returns didn’t become available for the index until 1997, but the Q2 figure was the 7th worst hedged return on record (March 2020 is #1 at -4.9%). For 1H 2022, the index underperformed Treasuries by 1.92%, also the 7th worst on record.
Looking Ahead
There have been flashes of stability in financial markets in 2022, but they have been short lived. As we have noted in recent commentaries, heightened volatility will likely remain a prominent theme until there is evidence of inflation reversing course. Recession talk will likely continue as well, as consumers and businesses both deal with the impact of inflation and tighter financial conditions. However, Fed Chair Powell has made it clear that he and his colleagues will not slow or end the tightening efforts until there are clear and sustained signs of inflation returning to the Fed’s long-run target, even if it brings economic pain in the process. On a positive note, we are beginning to see some signs of abating inflation pressures. The Bloomberg Commodity Index has fallen 15% since June 9 to the lowest level since late February, and a Wall Street Journal article on July 4 highlighted waning demand for semiconductors driven by a slump in personal computer sales and the round in cryptocurrency markets.
For fixed income markets, the second half of 2022 shouldn’t be a repeat of the carnage of the first six months, but it’s likely premature to expect a reversal of the negative performance experienced thus far while the Fed and other central banks continue to withdraw the extraordinary stimulus of the prior two years. The next major economic data points for markets will be the June jobs report (July 8) and the June CPI report (July 13). However, before those reports are released, the May job openings data (JOLT survey) will be released on July 6, and an “unhealthy” ratio of openings relative to total unemployed persons has been highlighted multiple times by Fed Chair Powell as an area of interest/concern.
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