The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Fixed income investors just experienced a “once-in-a-career” market correction: a 10% decline in the Bloomberg Barclays US Aggregate Bond Index (the “Agg”) through the first four months of 2022. For most allocators, this sharp downturn came in tandem with a painful equity market sell-off that has produced a -15% return for the S&P 500 Index year-to-date. It’s been rough sledding for traditional assets so far this year.
The forces behind the fixed income correction are by now familiar to market participants: rising interest rates, triggered largely by higher and stickier inflation than expected, and a scramble by the US Federal Reserve (Fed) to play “catch up” — in other words, to rein in inflation before a vicious cycle of surging wages and even higher prices takes hold. What now? I’m still hesitant to call a “top” for how high 10-year US rates might climb (beyond 3%) because the trajectory of future inflation remains highly uncertain, but I see tentative signs that we may be nearing a plateau. Below are four considerations that have me leaning that way.
1. How much monetary policy tightening is already priced in? A lot. As Figure 1 illustrates, according to the Fed Funds futures market, many investors now anticipate that the Fed Funds rate will reach 3.2% by the end of 2023, some 200 basis points (bps) higher than its current level of 75-100 bps. Fed Chair Powell was not particularly dogmatic when asked recently to identify a “neutral” Fed Funds rate, but he cited a range of 2.0%-3.0%. So, at 3.2%, the market apparently believes the Fed needs to pursue more restrictive monetary policy in order to “break inflation’s back.”
2. Is the economy responding to higher interest rates? The economy and markets seem to be reacting more to prospective Fed tightening than to actual tightening. Typically, the real economy responds to higher rates with a lag time of 6-12 months. However, as Figure 1 shows, a bellwether index of financial conditions (including mortgage rates, asset prices, credit spreads, and money supply) has already drifted lower in response to this year’s “rate shock” (i.e., a 150-bp spike in the 10-year Treasury yield). US manufacturing, home sales, and export data have also dropped lately, albeit from strong levels.
3. What will it take for the Fed to step back from tightening? Lower inflation and weaker demand. Last week, Chair Powell said it would likely take several months of lower core inflation for the Fed to retreat from its planned 50-bp rate hikes. Powell also mentioned “financial conditions” as something the Federal Open Market Committee (FOMC) will be watching closely, along with the labor market. Rising unemployment or any hints of growth dipping below trend might cause the Fed to pause on rate hikes.
There could also be a path forward where the market more or less “does the Fed’s work for it.” Indeed, it already has to some extent: Without having even tightened policy much (yet), the Fed’s more hawkish rhetoric has itself helped the fixed income market adapt to the reality of higher bond yields. Plus, a strong US dollar is also disinflationary. To preserve credibility, the Fed may need to meet the market’s already priced-in rate-hike expectations, but tougher financial conditions or falling inflation might give the Fed leeway to pull back from tightening.
4. What could go wrong from here? The Fed is in uncharted territory with regard to monetary tightening given: 1) the gap between current inflation and the Fed’s target; and 2) the use of tightening to pare back the Fed’s balance sheet, simultaneous with outright rate hikes. The Fed’s estimate that its balance sheet “run-off” is equivalent to only 25 bps of tightening seems quite low. Moreover, the Fed’s mistaken assumption last year that inflation would prove transitory delayed the beginning of its rate hikes. As a result of the Fed being “late to the game,” US monetary policy remains accommodative, with real (inflation-adjusted) 10-year interest rates still negative as of this writing.
Inflation is the wildcard: The Fed continues to believe higher commodity prices and supply-chain disruptions from the Russia/Ukraine war and China’s COVID lockdowns will ease. If they don’t, the Fed may decide to tighten policy more aggressively than the market currently expects. Under that scenario, Fed “overtightening” could tip the US economy toward recession, especially if paired with economic and market volatility from ongoing geopolitical turmoil or other sources. On the other hand, if the Fed pulls back and the market doesn’t believe inflation is under control, the Fed’s credibility is at risk.
1Positive carry is an investment strategy that involves investing borrowed money and then earning a profit on the difference between the return and the interest owed. Investors commonly use positive carry in currency markets.
Income: the hard worker in your portfolio deserves more credit
Continue readingHow to nurture a growth mindset in a higher-yielding landscape
Continue readingURL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Weekly Market Update
What do you need to know about the markets this week? Tune in to Paul Skinner's weekly market update for the lowdown on where the markets are and what investors should keep their eye on this week.
A turning point for US small caps
Myth busting US small caps: why now could be a compelling entry point for the asset class.
Four questions for investors after Japan’s historic hike
With the Bank of Japan having finally moved out of negative rates, Macro Strategist John Butler identifies the four key questions he believes investors should focus on.
Do fundamentals support a risk-on tilt?
Surprisingly strong economic growth, declining inflation, easy financial conditions — can it get any better for markets? Members of our Investment Strategy & Solutions Group offer their outlook, including their latest views on equities, bonds, and commodities.
Will proposed corporate governance reforms help to narrow the “Korea discount”?
Could South Korea's Corporate Value-up Program help to narrow the so-called “Korea discount” and build on the momentum gathering pace elsewhere across Asia to improve corporate governance and shareholder returns?
Income: the hard worker in your portfolio deserves more credit
Income from cash is good but income from bonds is better. In a less certain macro environment, Alex King, Supriya Menon and John Mullins think the case for income only gets stronger. How can investors make the most of opportunities?
How to nurture a growth mindset in a higher-yielding landscape
In a higher-yield world, can fixed income deliver meaningful growth? John Mullins, Supriya Menon and Alex King explore how high-yield bonds may offer a powerful opportunity for growth - as well as a cushion against uncertainty.
Managing currency exposure in multi-asset portfolios: how to weigh the trade-offs and impact
Nick Samouilhan, Head of Multi-Asset Strategy – APAC, evaluates the trade-offs of different currency hedging approaches and offers a novel framework for gauging their potential portfolio impact.
Thematic investing focus: security in a world of great-power competition
In an environment of accelerating great-power competition and geopolitical instability, policymakers may place a higher emphasis on security – even at the expense of economic efficiency. What could this mean for thematic investors?
Why income-seeking investors need to look across asset classes
Income plays an even more crucial role in portfolios than many of us realise, contributing a significant portion of returns for multi-asset portfolios. But with cash rates at around 5%, the world of income has changed. This should prompt investors to take a fresh look across asset classes to see where opportunities lie.
URL References
Related Insights
