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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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