(Bloomberg) – Negative annual yields on U.S. Treasuries are rare, and when they do appear, for a generation, they’ve always been followed by a rebound. BlackRock Inc. and Vanguard Group Inc. see this relationship in jeopardy next year.
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The Bloomberg US Treasury Index returned minus 2.5% in 2021, on the verge of its first annual decline since 2013. In records dating back to 1974, it has never fallen for two years in a row.
With yields still low by historical standards and the Federal Reserve poised to raise interest rates to fight inflation, some investors are bracing for more losses next year.
“A repeat of 2021 is a reasonable expectation for Treasury market returns in 2022,” said Jean Boivin, director of the BlackRock Investment Institute, the asset manager’s internal think tank. “If inflation slowly declines from where it is now, there is a risk that the performance of Treasuries will decline next year.”
This would create a headwind for the popular 60/40 strategy, which allocates portfolios in stocks and bonds, leaving investors to rely on stocks and riskier debt to generate positive returns.
While high-yield equity and credit valuations are expensive, BlackRock expects 2022 to generate global equity gains and bond losses for the second year in a row, the first of those results based on data from the company dates back to 1977.
“Our baseline scenario for 2022 is that growth and risky assets hold together and the market feels comfortable with the Fed tightening after the first quarter,” said Brian Quigley, manager of senior portfolio at Vanguard Group. “It’s moderately bearish for Treasuries.” Quigley sees 10-year bond yields rise to around 2%, from a close of 1.51% at the end of 2021.
This return forecast rhymes with the average estimate from a Bloomberg survey of strategists for the end of 2022. If that happens, it will lead to returns on Treasuries. And, as seen this year, low levels of fixed Treasury coupons are not only negative in inflation-adjusted terms, they cannot offset much of a fall in prices.
While the Bloomberg Treasury Index has generated a positive coupon of 1.5% so far this year, this modest income stream has been drained by a price return of minus 4% due to the rise in overall returns since. January.
The Bloomberg Treasury Index registered only four annual declines before 2021: in 1994, 1999, 2009 and 2013. It always rebounded the following year, with gains of between 5.1% and 18%. This time, an unwelcome slice of history awaits you.
“There is a first time for everything, and the chances of a second consecutive negative year for Treasuries are higher given the limited scope for falling yields,” said George Goncalves, head of macro strategy American at MUFG.
Concerns about the shutdowns hitting the economy early next year have prolonged a notable decline in benchmark Treasury yields since they peaked in late November. Demand for safe-haven securities may contain yields until January, leaving the market vulnerable if economic data shows resilience and the Fed remains committed to raising rates soon.
The first week of January is packed with economic data, supplemented by the December jobs report. Economists expect 400,000 new jobs, against 210,000 the previous month. Wage gains over the previous 12 months are expected to decline to 4.2%, from 4.8% for the year ending November. The bond market will also be looking at the minutes of the Fed’s policy meeting last month to get a feel for how the committee is looking at the timing of a first rate hike expected in 2022.
“An important point of the Fed’s recent communications is that the reaction function next year may be more hawkish than expected,” said Lou Crandall, chief economist at Wrightson ICAP. “The Fed has indicated it cannot ignore inflation,” and this may well see the central bank considering raising rates in March, although such a move will depend on how the economy behaves with it. the latest wave of Covid, Crandall added.
The prospect of rate hikes starting next year has naturally pushed up policy-sensitive short-term yields. In contrast, 10-year and 30-year bond yields remain below their 2021 highs, causing the Treasury yield curve to flatten sharply. Once the Fed does indeed start raising its overnight rate, the flattening trend will remain dominant, but the curve should move upward as well. “Once the Fed tightens, the curve will flatten bearish,” said Quigley of Vanguard.
Another aspect of the Fed’s tightening cycle in 2022 that may well drive up long-term Treasury yields and hurt yields is how the central bank manages its large balance sheet, which has more than doubled to near 9 Trillion dollars during the pandemic.
“The Fed might not repeat the last cycle, with only regular rate hikes,” Gonçalves said. “Shrinking the balance sheet is an option and the Fed has the tools to steepen the curve.”
One aspect of the Fed’s and bond market tightening early next year is that it could cause stocks and risky assets to fall sharply. A bout of risk aversion could limit and potentially reward holders of Treasury index products in 2022. Prior to the onset of Covid in early 2020, the 10-year Treasury yield was around 1.8% and its fall. At a low of 0.31% helped portfolios broaden the blow to stocks and credit.
“T-bills and duration have proven their worth as a diversification asset in 2020, and the 10-year is not that far below its pre-Covid yield,” Quigley said.
Still, with the central bank on the line, the broader market looks set for a rough time to avoid an untoward achievement of repeating a second consecutive negative annual total return.
What to watch
January 3: Markit Manufacturing and construction spending in the United States
January 4: ISM manufacturing and JOLTS job offers
January 5: ADP job, Markit US services and PMI composites, FOMC report
January 6: Trade balance, jobless claims, ISM services, durable goods orders
January 7: employment in the United States
January 6: James Bullard, president of the Saint-Louis Fed
January 7: Mary Daly, president of the San Francisco Fed, Raphael Bostic, president of the Atlanta Fed
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