TARA Enters, May Stay Awhile

The investment mantra for 2023 may well be TARA (as in “there are reasonable alternatives” to equities), replacing TINA (“there is no alternative”), the dated dictum that for more than a decade claimed risky assets were the only game in town.

Many of you likely agree with me, but some might be skeptical given the many uncertainties that surround the outlook for both inflation and monetary policy and the potential impact on markets.

If you harbor any of those uncertainties, you may be at a decision point about whether to invest in bonds. In my view, there are likely to be three common threads in the decisions investors make in 2023:

1.??????Volatility: How much do I expect?

2.??????Dry powder: How much should I maintain should prices fall more?

3.??????Market timing: How willing am I to time a potential diversifier?

The last two questions are ultimately going to be up to each investor’s situation. But I will weigh in on the first one, where I have strong conviction: Interest rate volatility looks likely to plunge in 2023 compared to 2022.

The Case for Bonds in 2023

Before we delve into volatility, let’s first discuss valuations. The repricing of bond yields in 2022 has not only restored the potential for future capital gains, it has resulted in yield levels that look attractive against three metrics: expected inflation, risk-adjusted returns compared to riskier assets, and the long-term average for yields.

Given the low level of expected inflation evident in assets such as Treasury Inflation Protected Securities (TIPS), and the measurable difference in historical volatility between bonds and risk assets such as stocks, I will focus on comparing today’s yield levels versus the past.

The Bloomberg U.S. Aggregate (U.S. Agg) Index, a common benchmark, helps highlight the attractiveness of core bonds today. Figure 1 shows the yield on the U.S. Agg has risen from a low of about 1% two years ago to around 4.6% today, well above the 20- and 30-year averages of 3.3% and 4.35%.

Figure 1.

be sure, one’s judgment about that historical context may depend on whether one believes the 2010s – an era of yield repression driven by stimulus from the U.S. Federal Reserve and other central banks – should be excluded from that calculation.

Yet longer-term history provides even further context. Figure 2 shows the Bank of England’s policy rate dating back to 1694 (through 2016). It suggests that periods of high interest rates tend to be more anomalous than periods of low rates.

Figure 2.

On the other end of the spectrum, the judgment about the historical context also depends on whether one believes the recent surge in inflation heralds a sustained period of high interest rates that renders today’s yields “too low.” I do not, and would rather adhere to the adage “Don’t fight the Fed,” which has served investors well time and time again. Today, that means believing in the Fed’s ability to restore price stability and thereby improve the macroeconomic and investment outlook. That includes the outlook for bonds.

Mind you, inflation could well be higher in the 2020s than the ultra-low levels of the 2010s. While that could mean 2% inflation may become more of a target than a destination, even an inflation rate of 2.5% would not be much for a bond investor to sweat over relative to today’s yields.

Why interest rate volatility will likely plummet in 2023

My expectation that interest rate volatility will plummet next year is based on one simple estimate: the potential size of the forecast miss for the Fed’s policy rate next year compared with the miss seen this year. Here’s why:

At the start of 2022, both officials and market participants expected the Fed’s policy rate to reach around 1% by March 2023, a miss of about four percentage points relative to current pricing. Though investors could continue to underestimate how high the policy rate must go, and thereby result in a further repricing of financial assets, I would instead consider three reasons the rate (and therefore the scope of any further miss) would likely be contained:

1)?????A 5% policy rate is more like 6%. Quantitative tightening (QT), whereby the Fed reduces its holdings of Treasuries and mortgage bonds, has value in terms of its equivalence to changes in the federal funds rate. Consider the housing market, which has been stricken by higher mortgage rates that are the result in no small part of QT. As a rule of thumb, each $1 trillion of Fed balance sheet runoff may equal about 25 basis points or more in rate hikes.

2)?????A 6% policy rate (equivalent or outright) is high relative to expected inflation. Take a look at Figure 3. Even if one expects inflation to fall to no lower than 3% (markets are priced for it to fall into the low-2% area, eventually), then that would leave the real policy rate at 3%. In the 1980s, Fed Chairman Paul Volcker needed a 5% real rate, because inflation was deeply entrenched over years and the Fed had lost credibility with investors. Today, Chairman Jerome Powell is battling a problem that is a far shorter two years in duration, and the Fed remains credible. That’s arguably more than half the battle given the importance of inflation expectations to inflation outcomes.

Figure 3.

3)?????The Fed is only one of the “Three Fs” of tightening. Fiscal spending fell massively in the U.S. in 2022, by $1 trillion to $5.8 trillion, the effects of which aren’t as visible yet due to previous stimulus. Then there is the tightening of financial conditions, which is on par or greater than in the Global Financial Crisis, according to PIMCO estimates.

If there is another reason to be confident about the path for inflation and interest rates, it is the notion of a Keynesian endpoint (for more detail, see my previous article). Today, practical limits to the use of debt are compelling policymakers to pursue policies that have the “approval” of markets, and that is undoubtedly a good thing in my view.

The broad repricing of bond yields higher in 2022, combined with the possibility of a sharp reduction in interest-rate volatility in 2023, brings a brightened outlook for many segments of the bond market. It appears that TARA has firmly pushed TINA out of the building.

Tony Crescenzi is a market strategist and portfolio manager at PIMCO and is also a member of the firm’s investment committee.?Click here for more about Tony.

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