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Fixed income investors have experienced a “once-in-a-career” market correction: an 11% decline in the Bloomberg Barclays US Aggregate Bond Index (the “Agg”) through the first eight months of 2022, in combination with an 18% US equity market sell-off. In the current inflationary environment, fixed income has clearly not played its traditional protective role.
Rising interest rates, triggered largely by higher and “stickier” inflation than expected, and a scramble by the US Federal Reserve (Fed) to rein in inflation before a vicious cycle of surging wages and even higher prices takes hold, have been the drivers of the rout. What now? Ultimately, inflation will determine the path of rates going forward. However, here are three considerations that could support a contrarian view in favor of fixed income:
1. How much monetary policy tightening is already priced in? A lot. As Figure 1 illustrates, according to futures markets, many investors anticipate that the fed funds rate will reach 4.6% by mid-2023, some 200 basis points (bps) higher than its current range of 3.00% – 3.25%.
2. Is the economy responding to higher interest rates? To a degree. A bellwether index of US financial conditions has already dropped in response to this year’s spike in rates. The housing sector has cooled, supply-chain pressures have begun to ease, and the strong US dollar is disinflationary. Wages and shelter costs have continued to rise, though.
3. What will it take for the Fed to step back from tightening? Weaker demand and lower inflation. Fed Chair Jerome Powell has said it would likely take several months of lower core inflation for the Fed to consider retreating from hiking rates. A pattern of rising unemployment and below-trend growth might cause the Fed to pause on rate hikes.
The Fed is in uncharted territory, given the gap between current inflation (over 8%) and the Fed’s 2% target. Moreover, the Fed’s use of quantitative tightening to pare back its balance sheet, simultaneously with outright rate hikes, is untested. While the Fed is hoping its rate hikes will bring down inflation with only “some pain to households and businesses,” a deeper recession is a possibility. On the other hand, if the Fed pulls back and the market doesn’t believe inflation is under control, the Fed’s credibility would be at risk. In that scenario, inflation expectations could become “de-anchored,” pushing the 10-year US Treasury yield higher still.
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Peak inflation, back to goldilocks? Not so fast
Portfolio Manager Nicholas Petrucelli explains why the market could be underestimating just how complex and volatile the global economic cycle is and details the implications for inflation.
February Fed meeting: Chair Powell strikes a more optimistic tone
The Fed just might still be able to engineer the hoped-for "soft landing" but it's not going to be easy, says Fixed Income Analyst Caroline Casavant.
Why global investors should watch the Bank of Japan
Macro Strategist John Butler explores why global investors should watch the Bank of Japan and what is likely to happen next.
Spread the risk: Our top three fixed income diversifiers for 2023
Fixed Income Strategist Amar Reganti highlights three types of strategies that may be well positioned to provide fixed income portfolio diversification going forward.
CLOs: Poised to outperform in 2023?
Collateralized loan obligations (CLOs) have been sparking investor interest lately — and with good reason, say Investment Director Andrew Bayerl and Investment Specialist Celene Klimas.
Multi-Asset Outlook — A rocky road to recovery in 2023
Markets may be jumping the gun when it comes to expectations for a policy pivot and the likely risk-asset rewards. Members of our Investment Strategy team still see bumps in the economic road, though their outlook has brightened a bit when it comes to China and other emerging markets.
Could Japan face a UK-style pension crisis?
Investment Director Masahiko Loo explores the risks of Japan facing a UK-style pension crisis and identifies fundamental reasons that make Japanese pension funds inherently less vulnerable.
Take credit: Our five best credit market ideas for 2023
Fixed Income Strategist Amar Reganti highlights credit market opportunities that he expects to arise over the course of 2023, against a backdrop of slowing growth.
Navigating the new global economy in 2023
This executive summary distills the points of view of several of our 2023 Outlook authors. Discover the risks and opportunities they see as we enter a new economic and market regime.
High yield: Opportunity to pivot in 2023?
Our high-yield bond portfolio managers have a guardedly optimistic outlook on the market and believe security selection will be key to benchmark-relative outperformance in 2023.
Currency outlook: Nearing the end of USD exceptionalism?
Fixed Income Portfolio Manager Martin Harvey and Investment Communications Manager Jitu Naidu consider the present state of and outlook for the US dollar.