Bonds Start Bouncing Back in 2023 -- but for How Long?

Things looked like they were going great for the stock market early Monday, as the S&P 500 (^GSPC 0.11%), Nasdaq Composite (^IXIC +0.35%), and Dow Jones Industrial Average (^DJI 0.56%) all jumped out to big gains around midday.

Yet those advances reversed course throughout the afternoon, and in the end, only the Nasdaq managed to hold onto any gains at all.

Data source: Yahoo! Finance.

Even as stocks have tried to rebound from a tough year in 2022, investors in the bond market have also looked for signs of a potential recovery. So far, 2023 has been relatively kind to some bond investments, although most of them still have a long way to go to make back all of their lost ground over the past year.

Moving back in the right direction

Bond-market declines in 2022 were noteworthy for their size. Exchange-traded funds following standard broad-based bond benchmarks were down 13% in 2022, while some long-term bond funds suffered losses of 30% or more.

In the opening days of 2023, however, bond markets have moved the other way. That has helped push the iShares 20+ Year Treasury Bond ETF (TLT 0.24%) up almost 6% early in January. Bond ETFs with a wider set of holdings, including the iShares Core U.S. Aggregate Bond ETF (AGG 0.17%) and the Vanguard Total Bond Market ETF (BND 0.15%), have gained more than 2% in just over a week of trading this year.

Image source: Getty Images.

The reason is counterintuitive. Even though the Federal Reserve has remained adamant about keeping monetary policy tight in order to fight inflation, the central bank's direct impact on rates is largely limited to those on short-term bonds. The federal funds rate, for instance, is an overnight rate, and most of the bond benchmarks that follow it are for relatively short-term debt obligations more often measured in months than in years.

Short-term rates have indeed stayed high, but longer-term interest rates have started to come down. That's particularly important for the price action of the iShares 20+ Year Treasury Bond ETF, which concentrates its investment focus on long-dated debt issued by the U.S. Treasury.

It's reasonable to wonder how long-term rates could fall if short-term rates are rising. The answer is that investors don't believe that the Fed will be able to sustain short-term interest rates at current levels for very long. Lower long-term rates essentially represent their predominant view: that future interest rates will fall so low that it's smarter now to lock in a rate below current short-term rates.

Some dates to watch in the bond market

Of course, it's entirely possible that these early rises in bond prices could reverse themselves in short order. A few key dates are worth watching for bond-market investors:

• The Federal Reserve is scheduled to meet on Jan. 31 and Feb. 1 to discuss interest rates, with an announcement coming at the conclusion of the meeting. Many investors have expected that the Fed will further slow the pace of its interest-rate hikes to a quarter of a percentage point. However, if the Fed repeats what it did in December and boosts rates by half a percentage point instead, it would likely come as a shock to bond-market investors.
• On Thursday, Jan. 12, the Bureau of Labor Statistics will release December's report on the Consumer Price Index. Slowing inflation would bolster bond bulls' arguments, while a surprise spike in price pressures could send bond prices plunging.
• Lastly, the question of the debt ceiling is likely to come to a head sometime in 2023, although estimates vary greatly about whether it will happen midyear or later. Ongoing tension on the issue could cause turbulence in the Treasury market, particularly among international investors.

As important as the stock market is, the bond market is also huge and has a major impact on the financial industry. Keeping an eye on bonds makes sense even if you're primarily a stock investor. And it'll be interesting to see if 2023 turns out to be a better year for bonds than 2022 was.