Zooming in on Fixed Income as We Head into 2023

The Aiguille du Midi, neighboring popular Mont Blanc in the French Alps, is famous for having the highest vertical ascent cable car in the world, a vertigo-inducing ride that is equal parts scary and awe-inspiring (see Figure 1). The mountain is so high, and the incline so steep, that there is a rest stop complete with bar and café along the 9,200-foot vertical journey, almost anticipating that some riders will inevitably be too impatient, or frightened, to continue. Skiers who do complete the journey to the top are rewarded by over 14 miles of exhilarating slopes as they coast effortlessly (in good conditions) back down to the village of Chamonix, nestled in the valley below.

Figure 1: Aiguille du Midi Cable Car, Chamonix-Mont-Blanc, France

Source: Photograph by Navin Saigal, February 12, 2020

For many fixed income investors, the ascent of interest rates in 2022 has been similarly vertigo-inducing. However, history suggests that the higher the discount rate mountain rises, the longer the runway of positive returns that a fixed income investor can “coast” down on the other side - it’s just very difficult to identify exactly how high that peak (terminal rate) is, or once that peak is reached, what the slope on the other side looks like. Indeed, the current hiking cycle is the steepest in 15 years, and the market is projecting its peak to rival those of the ‘90s – creating a lot of vertical on the other side (see Figure 2).

Figure 2: The Fed Funds rate is expected to peak close to where it did in the 1990s

Sources: Federal Reserve and Bloomberg, data as of December 2, 2022

Contrary to what one might expect, investment inflows tend to dry up at higher yields, and to accelerate the lower bond yields go, the equivalent of a skier prematurely disembarking a chairlift, and then speeding up as they approach the end of that truncated run (see Figure 3). At times, this behavior can be the result of what an investor may need to do rather than what they may want to do, as we wrote extensively about in our May 2021 Market Insights commentary, “Investors’ Wants Can be Very Different From Their Needs,” briefly excerpted below: