Are Fed tightening expectations overdone?



Lisa Hornby
Head of US Multi-Sector Fixed Income

The Fed has followed through with a much-anticipated interest rate hike, raising the Federal Funds Target Rate by a quarter of a percent to 0.25-0.50%. It’s the Fed’s first hike since 2018 and comes in response to multi-decade highs in inflation.  

The Fed cannot ignore rising prices, but it is also hiking amid major geopolitical uncertainty and possibly slowing growth. The higher energy and food prices fuelling inflation, and exacerbated by the war in Ukraine, are likely to weigh on consumer demand. Rate hikes are aimed at curbing inflation, but will also usually impact growth too, as rising borrowing costs dampen activity.

The Fed has indicated a rapid tightening trajectory in 2022, which has caused significant rises in bond yields. But given the aforementioned factors, there are questions around how quickly and how far the Fed will be able to raise rates. A more moderate pace of tightening than expected would be supportive to bonds, with valuations now looking much more appealing following the sharp sell-off.

What is the yield curve telling us at the moment?

The yield curve has flattened dramatically over recent months. The difference between the 10 and 2-year US Treasury yields has fallen from 77 to below 25 basis points year-to-date. This suggests the market does see Fed tightening bringing inflation under control, but that it will also bring down growth.

The move in fixed income has been dramatic. Typically though, when you see dramatic losses in bonds, the best thing to do is stick with it. A lot of bad news is in the price now – more than eight rate hikes over the 12 months.

Two-year investment grade corporate bonds are now yielding 3%. That's a decent return on a very short duration instrument, with lower sensitivity to rate moves, in high grade bonds. That is also potentially attractive if you're worried about volatility. Historically, 1-3 year investment grade US corporate bonds, on a total return basis have only had a materially negative annual return once over the last 45 years and that was in 2008. At this point, yields would mathematically have to rise another 150 basis points approximately, from already elevated levels, for those bonds to incur capital losses. That is a significant good cushion and looks really favourable to a year ago when yields on those bonds were approximately 0.5-0.6%.

Is there a risk the Fed tightens so much as to damage the health of the economy and disrupt market stability?

That is certainly the risk and that is why markets have had such a tumultuous (and negative!) period this year. There is a scenario, however, where a soft landing is achieved, which would likely require inflation to peak in the next couple of months. We certainly think inflation is past its worse levels and starting to trend in the right direction, lower!

Recent data showed a month-on-month drop in the producer price index, albeit it is still elevated. So we are starting to see encouraging indications in the data, particularly excluding food and energy, though these are big components. But we are starting to see some tentative evidence of supply chain issues abating and, with prices higher, some demand destruction, which support the idea that inflation peaks in the next couple of months.

That would allow the Fed to temper its pretty aggressive hawkish rhetoric. In this event, they wouldn’t have to hike seven times in the next seven meetings. That would afford scope for the bond market, particularly the short and intermediate part, to perform better. And growth slows, but doesn't actually tip into a recession. Gas prices are off the highs, and there is always a chance of conclusion on the Russia-Ukraine war that would support this thesis. Assuming a soft landing would imply a good opportunity in risk markets, not just fixed income, but equities too.

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Lisa Hornby
Head of US Multi-Sector Fixed Income


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