In June of 2022 I wrote a blog post titled “Smooth or Bumpy?” that dealt with the gyrations in the bond markets. I summarized that some exposure to the “short” part of the yield curve was prudent given the volatility in rates that we were seeing during the inflation-fighting Fed tightening cycle that started in March of 2022. Please see the chart below showing the return volatility of longer bonds (LQD, the blue line) compared to shorter bonds (SLQD, the green line) updated to current.
Consequently, around that time all D&A accounts received an increased allocation to shorter bonds to help shorten bond duration and smooth their portfolio return profiles. Here we are now, 18 months later, and we have started to see some economic and capital market impacts.
The intent of the Fed tightening was to slow economic growth (i.e., reduce aggregate demand) to help curb inflationary pressures without causing a recession – a tall order! The reported inflation results for June 2023 show material impacts (see chart below). The monthly Consumer Price index (CPI) for June 2023 was a small +0.18% increase from May and a 12-month increase of +3.09% - certainly good progress, though still above the +2% Fed inflation target. There has been a dramatic downtrend in the 12-month CPI (the orange line) from when it peaked in June of 2022.
No one knows for sure, but signs of a “soft landing” are becoming clearer. With the decline in inflation, we see other supporting indicators showing positive effects including normalization of U.S. industrial production, continued low unemployment and declining inflation expectations. The higher interest rates we now have may still cause problems, especially in the real estate market, but if we get an easing in rates that should help.
This could translate to more normalcy in the bond market, thus reducing the need for excess diversification to the short end of the yield curve. D&A will maintain some exposure to the short end of the yield curve for diversification purposes, but we now favor a longer duration target and more focused return to long term strategic targets.