The Lost Decade
Bryan Taylor, Chief Economist, Global Financial Data
2022 was one of the worst years for fixed-income investors in history. Bonds lost money. Stocks lost money. Crypto lost money. Inflation rose to levels not seen since the 1980s. The only thing that increased in value were commodities. You have to go back to the Civil War in the United States or the Napoleonic Wars in Britain to find a worse year for bonds.
Nowhere to Hide
When Covid hit the world in March 2020 and businesses shut down, governments did everything they could to keep the economy from collapsing. The Federal Reserve and other central banks lowered interest rates to negative real levels to spur growth. The United States ran a government deficit equal to 10% of GDP to keep the economy afloat. After a sudden collapse in the stock market, equities made a dramatic reversal, hitting bottom in March 2020 and moving upward through the end of 2021.
After Covid began to subside, problems began to appear. Many people had been laid off during Covid, and some of them chose not to return to work. The labor supply tightened and, combined with the push for higher minimum wages, the cost of labor began to rise. When prices started to increase in 2021, the Federal Reserve warned that the inflation would be temporary and that investors should not worry about it, but inflation continued to rise and did not go away. It 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 Fed Raises Interest Rates
The Federal Reserve raised the Federal Funds Rate from 0.00%-0.25% at the end of 2021 to 4.25%-4.50% by the end of 2022 with future rate increases promised in 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. The European Central Bank Deposit Rate rose from 0.5% to 2% in 2022. The yield on the German 10-year Bund rose from -0.21% at the end of 2021 to 2.51% by the end of 2022. Interest rates rose rapidly throughout the developed world from their lowest levels in history at unprecedented speed.
Figure 1. United States 10-year Bond Yield, 1792 to 2022
Consequently, bond prices collapsed, and bond yields rose. 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. GFD’s Index of 10-year government bonds lost 3.93% in 2021.
To add insult to injury, inflation reduced real returns even more. Consumer prices rose 7% in 2021 and 6.5% in 2022. This means that after inflation, investors lost 11.2% in 2021 and 24.6% in 2022. This comes to a cumulative 38.6% loss in two years. As can be seen in Figure 2, the real yield to bond investors has been falling since 1981 and in 2022 fell to the lowest level since the 1940s. Despite an increase in the government bond yield, the real yield remains negative. To call these investments risk-free is truly an oxymoron.
Figure 2. United States Bond Yield After Inflation, 1792 to 2023
Bear Bonds
It is rare for GFD’s US Government Bond Index to decline two years in a row, and during the past 230 years, the index has never declined for three years in a row. In the past, most successive year declines were small, at only 2-3% each year. Only in 1860 and 1861 were there successive declines of 6.5% each year. The decline in 2021 and 2022 was unprecedented. Declines this large in successive years had never occurred in US history.
Given the Federal Reserve’s determination to keep interest rates low to help the economy, it seems inevitable that yields in 2022 will continue to increase. As Figure 2 shows, real bond yields have been declining steadily since 1981 and went negative during the past couple years. As Figure 3 shows, the Federal Reserve has kept the real Fed Funds Target Rate negative during most of the twenty-first century, reaching a negative 8% in 2022. Only toward the end of 2022 has the combination of lower inflation and higher interest rates, pushed the real Fed Funds Official Target Rate to a negative 2%. One wonders how much longer negative real interest rates will persist. The Fed policies are not friendly to those who save.
Figure 3. USA Fed Funds Official Target Rate Adjusted for Inflation, 1955 to 2023
Between July 2020 and October 2022, GFD’s index of 10-year US Government bonds declined by 24.75%. It has truly been a bear market for fixed-income investors. The losses in 2022 brought fixed-income investors back to where they had been in 2014. And this ignores the impact of inflation. Certainly, investors in risk-free government bonds in 2014 did not expect to look forward to 2022 with no gains. Stock markets only took investors back to where they had been in 2020. It will take years for fixed-income investors to recover these gains.
If you look at other bond indices, you get similar results. The Bloomberg Aggregate Bond Index peaked in July 2020 and fell 16.73% by October 2022. The Aggregate Bond Index fell by 1.53% in 2021 and by 13.01% in 2022. The Dow Jones Corporate Bond index declined by 23.5% between December 31, 2021 and October 21, 2022. It declined by 1.35% in 2021 and by 16.85% in 2022. No matter how you look at it, bonds have been in a bear market during the past two years.
The only worse twelve-month return to U.S. Government bonds during the past 230 years was in 1861 at the beginning of the Civil War. Between April 1860 and April 1861, investors would have lost 23.1% of their investment as the price on the US 5% Bond due in 1874 fell from 103.125 to 75.25. Only during wars have fixed-income investors had worse returns.
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 reduces 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 such large declines simultaneously.
With bonds down 17% and stocks down 20.8% in 2022, the decline for the 60/40 portfolio in 2022 was 19.3%. The only worse year on record was 1931 when the stock market declined by 42.2% and bonds by 2.6% producing a 26.3% decline in the portfolio. Since this came in the midst of a 9.3% decline in consumer prices, after adjusting for inflation, the decline in 2022 was even worse than the decline in the portfolio in 1931. Similar years of large declines in stocks, such as 1907, 1917, 1930, 1974 or 2008 had small declines in bonds which reduced the overall losses in the portfolio. For example, the 30.3% loss in stocks in 1937 was offset by a 1.2% gain in bonds.
You also have to remember that the losses in 2022 occurred during a period of rising inflation. Consumer prices rose by 6.5% in 2022, certainly not as bad as the 9% to June 2022, but worse than any year since the 1980s. Adjusting for inflation, investors lost over 23% in bonds and over 25% in stocks during 2022. There was truly no place to hide.
It may take only a couple years for equity markets to recover from this bear plunge, but bond markets can take five years or more to recover from a decline of this magnitude. 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
GFD keeps track of the long-term return to bond investors over the past 230 years. Returns fluctuate from one year to the next, but keeping track of annualized returns over a period of ten years enables us to analyze long-term trends in the bond market. 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 2012 is calculated as the difference between the value of GFD’s 10-year US Government Bond Index in 2022 and 2012 converted to an annual return. The chart appears to have a 50-year cycle with low returns in 1804, 1824, 1851, 1901, 1949 and 2012. If you look at Figure 4, you can see that after hitting a low, the 10-year annualized average inevitably starts to move back up. If the Fed had not kept interest rates low after the Great Financial Crisis in 2008, the 50-year cycle might have been completed.
Figure 4. Ten-year Annualized Returns in the United States 1792 to 2022
The importance of this graph is illustrated in Figure 5 which compares the yield on government bonds and the return to an index of 10-year government bonds. There is a very strong correlation between the two of them. 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 the bond until maturity or if you had left the money in an ETF that invested in 10-year government bonds. When the price of bonds increase, the yield declines to offset the capital gain. As Figure 5 shows, changes in yield and return offset each other for this reason. Going forward, the return to fixed-income investors is likely to increase from the lows the index hit in 2022.
Figure 5. Yields and 10-year Annualized Returns to 10-year Government Bonds, 1920 to 2022
Based upon this graph, it seems unlikely that even if bonds recover from their current bear market, high returns are likely. The market will probably settle down to returns of two to three percent during the rest of the decade.
The Lost Decade
Fixed-income investors have just endured one of the worst bear markets in history. The only times in the past when investors received worse returns was when there was a war or inflation occurred. US investors haven’t seen a worse year since the Civil War and UK investors since the Napoleonic wars.
During the past 230 years, US fixed-income investors have never suffered three successive years of losing money in government bonds. We predict that fixed-income investors will receive a positive nominal return during 2023, but after inflation, they may face a third year of losses. They should expect low returns for the rest of the decade. In fact, it may be 2030 before fixed-income investors have fully recovered from the losses of the past two years.
US Government bonds have provided positive nominal returns 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, and five decades since bills beat bonds, but we may return to negative real returns in the 2020s and a decade during which cash provides a higher return than government bonds, even though inflation is likely to beat cash. Government bonds will require a 1.8% annual return and a 4% real return to break even in the 2020s. Although the nominal return seems possible, the real return seems unlikely.
The 2020s may truly be a lost decade for fixed-income investors.
