Investors Profit from Bond Reversal in 2023
Bryan Taylor, Chief Economist, Global Financial Data
2022 was one of the worst years for fixed-income investors in history. Bonds lost money for the second year in a row. Stocks lost money. Crypto lost money. Inflation rose to levels not seen since the 1980s. You have to go back to the Civil War in the United States and the Napoleonic Wars in Britain to find a worse year for bonds. There was nowhere to hide.
2023 provided relief. The S&P 500 returned 26.29% and the US 10-year government bond returned 4.35% reversing two years of losses. Crypto rose in price during 2023, but commodities declined. During the 2020s, stocks in the U.S. are up 57.6% so far, but bonds are down 8.16%. It will take two more years for bonds to provide a positive nominal return in the 2020s, assuming no increase in bond yields and decline in bond prices.
So are the bear markets and losses of 2021 and 2022 over with? Will stock and bond markets return to positive returns for the rest of the decade, or are financial markets doomed to fall back into a bear market?
The Fed Stops Raising Interest Rates
When prices started to increase in 2021, the Federal Reserve warned that inflation would be temporary and that investors should not worry about it, but inflation continued to rise and did not go away. Inflation peaked at 9.1% in the United States in June 2022. In February 2022, Russia invaded Ukraine. This pushed up commodity prices, feeding the inflation that had already built up in the economy. By the time the Fed was willing to admit that inflation was approaching levels the developed world hadn’t seen in 40 years, it was too late. The Federal Reserve and other central banks had to act quickly to stop inflation from becoming endemic in the economy.
The Federal Reserve raised the Federal Funds Rate from 0.00%-0.25% at the end of 2021 to 5.25%-5.50% in July 2023. The yield on the 10-year Government Bond in the United States rose from 1.52% at the end of 2021 to 3.88% by the end of 2022 and 4.88% at the end of October 2023. GFD’s Index of returns on US 10-year bonds showed a decline of 17% in the year to December 2022. This was the second year in a row that US fixed-income investors lost money. Who says that government bonds are risk-free?
To add insult to injury, inflation reduced real returns even more. Consumer prices rose 7% in 2021, 6.5% in 2022, and 3.35% in 2023. This means that after inflation, investors lost 11.2% in 2021 and 24.6% in 2022. This came to a cumulative 38.6% real loss in two years. By the end of October 2023, bond yields had risen to 4.88% generating an additional 2.6% loss for fixed-income investors. At that point, someone investing in 10-year bonds at the end of 2011 would have just broken even twelve years later. There were predictions of bond yields rising to 5.50% by the end of 2023 which would have created an unprecedented third year of losses to fixed-income investors.
But it didn’t happen. Instead, lower consumer price data increased the likelihood that the Fed would lower interest rates earlier and more frequently in 2024 than investors had previously expected. This caused bond yields to drop by a full 100 basis points from 4.88% to 3.88% by the end of the year. Bond investors breathed a sigh of relief. Figure 1 shows, the history of government bond yields in the United States. The yield has stopped its steady decline from 1981 to 2021 and has stabilized at around 4%.
Figure 1. United States 10-year Bond Yield, 1786 to 2023
As can be seen in Figure 2, which uses GFD’s graph for bond yields after inflation, the real bond yield, also fell between 1982 and 2022, declining from almost 10% in 1982 to -7% in 2021, its lowest level since the 1940s. In 2023, however, real bond yields returned to positive territory, though barely.
Figure 2. United States Bond Yield After Inflation, 1900 to 2023
The Impact on a Stock-Bond Portfolio
Most investors reduce their risk by investing in both stocks and bonds simultaneously. The recommended ratio for investors is 60% in stocks and 40% in bonds. Since bonds typically have less volatility than stocks, when there is a bear market in stocks, lower or no losses in bonds will reduce the overall decline in the portfolio. By putting the majority of their money in stocks, investors can still benefit from bull markets while reducing their downside risk. Unfortunately, in 2022, both stocks and bonds declined by over 15%. This was the first time in history that both stocks and bonds showed double-digit declines simultaneously.
2023 provided positive returns to both stocks and bonds. Stocks returned 57.6% between 2020 and 2023 while bonds lost 8.2%. Bond investors could make up the nominal losses of 2021 and 2022 in five years. But what about inflation? After inflation, stocks returned 38.5% between 2020 and 2023, but bonds lost 23% between 2020 and 2023. With bonds yielding only 1% more than inflation, it could take 20 years for bond investors to return to where they were at, in real terms, at the beginning of 2020.
The losses that occurred in 2021 and 2022 cannot be undone. The only consolation is that the worst is over with, and even if markets recover slowly over the next few years, they are recovering.
The 50-year Yield Cycle is Completed in 60 Years
Since 1900, there have been two broad rises and declines in bond yields in the United States. The first occurred between 1900 and 1945, with interest rates peaking in 1920. The second occurred between 1945 and 2020, with interest rates peaking in 1981. These two interest rate pyramids occurred in Europe as well as the United States. If you look at Figure 3 you can find annualized returns to investors in 10-year US Government Bonds over a period of 10 years between 1792 and the present. The value for 2013 is calculated as the difference between the value of GFD’s 10-year US Government Bond Index in 2023 and 2013 converted to an annual return. Not surprisingly, it resembles the yield on the 10-year bond that is illustrated in Figure 1.
We believe that bond returns have hit a sixty-year low and will probably be higher for the next 50 years as a new interest rate pyramid begins. We cannot predict how high bond yields will rise, but based upon past evidence, it will take ten to twenty years for bond yields to reach their new peak. Rising bond yields mean lower bond prices, reducing the total return to fixed-income investors. If you had bought a 10-year government bond in 1981, you would have received about a 15% return on the bond over the next ten years whether you had held on to a single bond until maturity or if you had left the money in an ETF that invested in 10-year government bonds because declines in bond yields are offset by capital gains in bond prices.
Figure 3. Ten-year Annualized Returns in the United States 1792 to 2013
Predictions for 2024
Entering 2024, there are many reasons for uncertainty. Two wars continue to rage in Ukraine and the Middle East and a third war could erupt in Taiwan or elsewhere. There are elections scheduled in over 50 countries in 2024, including the United States, India, Russia, Taiwan, and South Africa. Trump could be re-elected President of the United States. Inflation could return and anticipation of interest rate decreases could prove false. There are many reasons for unexpected shocks to prevent financial markets from performing as well in 2024 as they did in 2023.
2024 is an election year and stock markets display a distinct pattern over the four-year Presidential cycle. The best performing returns occur in the year before elections (2023) when politicians spend money to make the economy perform well to increase their chances of being re-elected. The worst performing returns occur two years before the election (2022). Most losing years occur in the middle years of the Presidential Cycle. Returns in the year of the election are higher than average.
Election years have provided negative returns only twice (2000 and 2008) in the past sixty years. Both of those losses occurred after bull markets peaked in the previous year. Those elections also led to a change in the party in power in the White House. Based upon these historical trends, we believe that 2024 is likely to be a positive year for the stock market, though not as strong as 2023. We also believe that 4% is the “new normal” for bond yields with a real return of 1-2% per annum. Although it may take many years for fixed-income investors to recover from the losses of 2021 and 2022, recovery is on the way.
US Government bonds provided positive nominal returns during every decade since the 1790s, but after adjusting for inflation, bonds provided negative returns in the 1940s, 1950s, 1960s and 1970s. It has been five decades since inflation beat bonds, but because of the losses in 2021 and 2022 we may return to negative real returns for bonds in the 2020s, though positive nominal returns.
In short, the worst is over with. Stay invested in stocks and bonds in 2024.
