Total Return Outlook: Can I Have Another (Rate Hike)?

2022 saw the worst annual return for investment grade fixed income since the Bloomberg U.S. Aggregate Bond Index (Agg) began tracking in 1976. The fed funds rate was lifted by 425 basis points in just nine months. The last time we witnessed rate hikes of this magnitude was between 2004 and 2006, when Chairman Greenspan authorized seventeen consecutive 25 basis point hikes over two years. And yet, it seems that we are not quite done with this tightening cycle.

As fixed income investors, our focus for 2023 is singularly on the Fed’s battle against inflation and its impact on the markets. Although the central bank maintains its dual mandate of “price stability and maximum sustainable employment,” continued wage growth and tight labor markets should allow it to concentrate almost entirely on the problem of rising prices. It should be noted that the healthy labor conditions have contributed to inflation this year, suggesting (somewhat ironically) that the Fed has satisfied the employment portion of its mandate a little too well!

Required reading for 2023 is the transcript of the speech Chair Powell gave on November 30, 2022, titled “Inflation and the Labor Market.”1 He did a remarkable job breaking down the various drivers of inflation and addressed his expectation on how these drivers would evolve in the coming year. As the speech was not tied to a rate move or a Fed meeting it had more credibility as something of a reference tool rather than a form of market-moving policy suasion.

In this regard, we turn our attention to what we believe is the single most important data series to be tracked for 2023: the Underlying Inflation Gauge (UIG, Full Data Set), a time series we have referenced in past commentaries. It measures the persistent components of inflation, and it is as important now as ever. UIG peaked in March 2022 at 4.88% and has steadily declined to 4.14%. Unlike CPI, PCE, and other measures of inflation, UIG is relatively stable and exhibits significant inertia – which is intuitive since it focuses on the drivers of persistent inflation. It is reasonable to assume this index will continue to fall – with the primary question being when it will recede to something closer to 2%.