- Federal Reserve's interest rate hikes in 1980 sowed the seeds for a long-term rally in bond markets.
- But the same prescription, taken again last year to tame inflation, has hammered bond returns.
In the early 1980s, the Federal Reserve conquered high inflation with economically painful interest rate hikes that, in turn, planted the seeds for a 40-year bull market in fixed-income securities.
The run finally began to end March 17, 2022.
That's the day the Fed, after protecting the U.S. from pandemic calamity by maintaining its benchmark lending rate at a historic low of 0-0.25% for two years, raised rates for the first time since 2018.
It hasn't stopped yet. This week, the central bank pushed its rate up another 25 basis points to 4.75-5%, ithe highest since 2016, amid a battle to reduce the highest and most persistent inflation since the Reagan administration.
Along the way, financial casualties have mounted, with the fixed-income market one of the biggest. From U.S. Treasuries to investment-grade corporates, the past year has produced historic losses for bonds.
Genesis of a Long-Term Rally
The dawn of the 1980s featured a mix of geopolitical and economic gloom: the Iran hostage crisis, the Soviet Union's invasion of Afghanistan, and a U.S. economy plagued by high inflation.
Fed Chairman Paul Volcker led the charge against rising prices. With annual inflation reaching 13.5%, the Fed in December 1980 essentially kickstarted a U.S. recession by pushing its rate to an almost unimaginable 19-20%.
The plan worked. Consumer inflation fell to 10.3% in 1981 and 6.1% in 1982. It didn't top that level again until last year.
The Bond Bull Runs—For Years
The bond market—albeit with some hiccups—enjoyed a glorious run in the four decades in between.
Unlike stocks, for which bear and bull markets are defined by a 20% change in value, bond market runs don't have similarly established start-and-end values. Instead, bond bull markets merely reflect a prolonged downward trend in interest rates, and vice-versa for a bear market.
Bond prices move inversely with yields, and yields began a long-term downtrend in late 1981. The benchmark 10-year U.S. Treasury yield—used to price large swaths of fixed-income securities—peaked on Sept. 30 of that year at an all-time high of 15.84%.
By August 1986, the 10-year yield had dropped below 7% as the Fed steadily reduced rates from earlier in the decade. It rebounded to almost 8% by the start of the 1990s but fell below 5% after 9/11.
Seven years later, the Fed reduced rates to historic lows during the global financial crisis and maintained an accommodative monetary policy for much of the next decade. The 10-year yield fell as low as 1.43% in July 2012 and never breached 3.2% prior to last year.
During the pandemic, the Fed reduced rates again. Simultaneously, additional extraordinary monetary and fiscal policy measures taken to protect the economy—including the Fed's purchase of government bonds—pushed the 10-year yield to an all-time low of 0.52% in August 2020.
Here Come the Rate Hikes
The 10-year yield rose as the pandemic eased and the economy strengthened but didn't exceed 2% until the Fed telegraphed its rate hike campaign in early 2022.
The Fed's first move in March pushed the 10-year rate as high as 2.48% that month. By June, it was near 3.5% and by October, it reached 4.25%—almost tripling the level at which it started the year.
While bond yields have wavered as recession concerns have increased, the 10-year yield remains about twice as high as it was a week-and-a half before the Fed's first rate hike last year. Meanwhile, the Fed indicated this week it hasn't stopped raising rates and has no plans to reduce them this year.
Bond Market Impact
With rates rising, fixed-income securities have suffered historic losses.
U.S. Treasuries and investment-grade corporate bonds lost 17.3% and 14.5% of their value, respectively, in 2022—the largest single-year losses either has suffered based on records dating to 1928.
By comparison, Treasuries since 1980 had posted double-digit annual percentage gains in 16 years, with investment-grade corporate bonds doing so 21 times in that period. Treasuries had annual losses only seven times in that time frame, with just five annual losses posted by investment-grade corporates.
The bond market has stabilized since the beginning of the year, with the Bloomberg Global Aggregate and U.S. bond indices up 2.7% and 3.1%, respectively. But they've still lost 8.2% and 4.8% since the Fed began raising rates last year.
Likewise, other fixed-income securities have endured substantial losses.
The Bloomberg U.S. Mortgage-Backed Securities (MBS) Index fell 12% last year before rebounding 3.4% year-to-date, the Bloomberg Corporate High Yield Index dropped 11% in 2022 (up 2.2% year-to-date), and the Bloomberg Municipal Bond Index declined 9% (up 2.1% year-to-date).
Inflation, of course, is a mortal enemy for fixed-income investments. But so are rising interest rates. With the latter deemed necessary to slay the former, bond investors at least hope their Fed-inflicted losses are worth the pain.