The average U.S. bond had a negative total return in 2021 for the first time since 2013.

The fourth quarter was another volatile one for interest rates as credit markets grappled with elevated inflation, the prospect of slowing economic growth in 2022, and the onset of the COVID Omicron variant. Notably, the yield curve flattened considerably during the quarter.

In early December, the Bureau of Labor Statistics reported the highest inflation rate since 1982. Higher inflation has primarily been due to supply and labor shortages, and tremendous consumer demand for goods as the economy recovers from the pandemic. Although the Federal Reserve continues to view the current inflation situation as short-term in nature, the Fed did indicate a more aggressive stance on tightening monetary policy in 2022.

In the Fed’s December meeting, they announced their decision to accelerate the taper of bond purchases to $20 billion per month of U.S. Treasuries and $10 billion per month for U.S. Agency mortgage-backed securities. This will effectively end the Fed’s quantitative easing program a few months earlier than originally expected. The Fed also indicated they are likely to increase the federal funds rate at least twice, and possibly three times, in 2022.

In reaction to this news, the yield on short-to-intermediate term Treasury bonds (6-month to 7-year maturities) rose significantly during the quarter, while longer-term yields (10-year + maturities) were flat to slightly down. The widely watched 10-2 Treasury Yield Spread (the difference in yield between 10-year Treasuries and 2-year Treasuries) narrowed from 1.24% at the beginning of the fourth quarter to 0.79% at year-end. As a result, the slope of the yield curve flattened as can be seen in the following chart.

This flattening of the yield curve indicates the bond market considers multiple increases in the federal funds rate to be very likely in 2022, while at the same time, longer-term economic growth is likely to moderate from the torrid pace we experienced in 2021 as the economy has largely recovered from the pandemic.

For the broader bond market, the average U.S. bond had a negative total return in 2021 for the first time since 2013, losing -1.54% for the year. Municipal bonds and junk bonds were the only issuers posting positive total returns for the year.

We continue to see a number of headwinds for the bond market as we start 2022. Success in this asset class will be driven by a selective approach to targeting the best risk-to-reward areas of the yield curve.