Bonds Begin 2023 With a Surge

U.S. Treasurys are starting the year off strong in 2023, giving investors some hope after a historically terrible year for bonds.

Treasury yields declined significantly in the first week of the year, helped by positive inflation readings in Europe and weaker-than-expected economic data from the United States. Friday's reports on average hourly earnings and service-sector activity came as a surprise to many investors, who had been expecting stronger numbers.

Many investors believe that wage growth is a major driver of inflation. The new data is seen as a positive development that could ease pressure on the Federal Reserve to keep raising interest rates. Expectations for short-term rates set by the central bank play a key role in determining the level of Treasury yields.

The Fed raised rates by a half a percentage point, or 50 basis points, at its last meeting in December. However, the recent jobs report suggests that the Fed may need to raise rates by another 25 basis points in February or March, according to Mike Sewell, a portfolio manager at T. Rowe Price.

Investors were not celebrating their success.

In contrast to the first week of 2022, last week saw prices of Treasurys immediately start to tumble. This set the tone for a year in which bonds delivered by far their biggest annual losses in records going back to the 1970s.

Despite a partial reversal of the jump in yields that occurred during the late December holiday season, yields remain higher than they were at the beginning of trading in 2023. Light trading during the holiday season can exacerbate moves in the market, which may explain the increase in yields.

The yield on the benchmark 10-year U.S. Treasury note settled at 3.570% on Friday, according to Tradeweb. That was down from 3.826% the previous Friday, but still up from around 3.45% on December 15.

A lot is riding on how bonds perform in 2023. Last year's disappointing performance, driven by persistent inflation and rising interest rates, hurt many financial markets, including bond funds, Tesla shares, and cryptocurrencies.

As yields on government bonds rose, stock prices fell to reflect the improved returns that investors could now get by holding these bonds to maturity. This was especially true for growth stocks, many of which are in the tech sector, that are valued primarily for the large profits that are expected to be generated further in the future.

Treasury yields are a key factor in determining interest rates across the economy, and thus the cost of a mortgage. Last year, the average 30-year fixed mortgage rate more than doubled, resulting in a sharp decline in home-buying activity.

There is considerable debate about how the Fed will achieve its goals of slowing the pace of economic growth and reducing inflation. Some believe that the Fed will need to raise interest rates significantly, while others believe that only a small increase will be necessary. There is also debate about how long the Fed will wait before cutting rates once it has stopped raising them.

The Fed's benchmark federal-funds rate is currently set between 4.25% and 4.5%. In December, the Fed's median forecast pointed to a 5.1% rate at the end of this year and a 4.1% rate at the end of 2024. These rates are both comfortably above what markets suggest that investors think is likely.

At the Fed's December meeting, officials were concerned that investors might think the Fed would lower interest rates, leading to "unwarranted easing in financial conditions" that could make the Fed's job more difficult.

Investors have become more confident in recent months that the year-over-year inflation rate will fall sharply in 2023, even when excluding volatile food and energy categories. This is largely due to a recent decline in the prices of core goods, such as furniture and video equipment, which has resulted from changing consumer spending patterns and improved supply chains.

Many investors believe that the economy will slip into a recession over the next 12 months, putting pressure on the central bank to start cutting rates. This is despite repeated statements from officials suggesting that they don’t envision any rate cuts this year.

Investors and Fed officials who are more worried about inflation persistence in 2023 generally accept that goods inflation is likely to moderate this year. However, their concern is that the prices of services will continue to rise rapidly as demand for workers remains high and businesses pass on their labor costs.

The wage data from Friday was encouraging, suggesting that the labor market is improving. However, other data points - including a report on job openings released on Wednesday - suggest that the labor market remains extremely tight, with demand for workers far exceeding the number of people looking for jobs. This indicates that there is still a lot of room for improvement in the job market.

Eddy Vataru, a fixed-income portfolio manager at Osterweis Capital Management, said that Friday's jobs report was "an easier one to swallow than the last two," but that there is still a long way to go in terms of the overall recovery.

Mr. Vaturu said that he doesn't think the Federal Reserve will lower interest rates this year. He believes that the central bank is getting close to the end of its rate-raising campaign, but "usually the Fed doesn't ease within months of reaching a terminal level."