2022 Mid-Year Outlook: Fixed Income

Our view was that the result would be rising interest rates and higher volatility, especially in the riskier segments of the markets. We suggested investors consider reducing duration and start being cautious about the credit quality in their fixed income portfolios.

There has been a parallel shift up in yields in the Treasury market, for bonds with maturities of two years or greater, as markets adjusted to the swift move toward tightening by the Fed. That resulted in a sharp decline in the prices of intermediate- and long-term bonds that are most sensitive to interest rate changes.

We estimate that the target range for the federal funds rate will end the year at 2.25% to 2.5%. Ten-year Treasury yields will likely trade in a 2.5% to 3.0% range but end the year closer to the low end of that range.

In addition, the Fed will be reducing the amount of bonds it holds. The current plan is to eventually allow up to $95 billion in bonds ($60 billion in Treasuries and $35 billion in mortgage-backed securities, or MBS) to mature without reinvestment. The plan suggests that the Fed is aiming to cut the size of the balance sheet back to pre-pandemic levels over the next few years.

Aside from the pandemic-induced plunge in March 2020, the Bloomberg U.S. Financial Conditions Index reading is now the tightest since 2018—near the end of the last Fed tightening cycle.

Rising real yields act to slow the economy by raising the hurdle rate that investors need to achieve over the risk-free (i.e., Treasury) rate. When money is cheap, borrowing and investing in even the riskiest markets can look attractive compared to negative returns in cash. However, as real yields rise, the hurdle rate needed to achieve attractive returns rises. Consequently, speculation and investment tend to slow as real rates move up.

It's not surprising that the most speculative and highly leveraged assets, which rely on ample amounts of liquidity to support valuations, are showing the biggest declines in the markets.

Even with the rising risk of recession, it's worth noting that each one is unique. The current environment seems most similar to the early 1980s. Inflation was high in large part due to oil price spikes. In response, the Fed raised nominal and real interest rates aggressively. The economy was otherwise relatively healthy, with a solid banking system and consumers who weren't overextended on debt. Nonetheless, there were two steep back-to-back recessions during that time period, from January to June 1980, and from July 1981 to November 1982. Housing and manufacturing experienced sharp declines and the unemployment rate soared to double-digit levels.

While the Fed is determined to push inflation lower, there's a good chance it won't have to go to the extremes of the early 1980s. Demographic trends are far different with the U.S. population aging. That tends to result in slower growth and inflation. Another key difference in policy this time around is the use of "forward guidance" by the Fed. In the 1980s the Fed provided very little information about its plans to the markets. Consequently, rate hikes often surprised investors, consumers, and businesses—increasing volatility. This time around the markets should be able to anticipate changes, mitigating some of the surprise factor that can create added volatility.

Currently, the economy is already starting to show signs of slowing down as interest-rate-sensitive industries like housing experience declining sales, manufacturing orders slow, and corporate profit growth flattens—all indicators that point to rising recession risk.

If we're right that the economy slows and inflation expectations ease, the Fed may not need to raise the federal funds rate beyond the 2.5% to 2.75% level. That should mean that intermediate- to long-term bond yields could edge lower.

Our preferred strategy is to gradually increase duration of bonds in portfolios at these higher yields. However, we favor higher-credit-quality core bonds, such as Treasuries and investment-grade corporate and investment-grade municipal bonds. In most cycles, yields tend to converge near the peak of the federal funds rate for the cycle. In the 3% region, yields have already discounted Fed tightening beyond the neutral rate.

Meanwhile, we do see potential opportunities for fixed income investors to benefit from the rise in rates. Yields on many fixed income asset classes have risen sharply since late last year. After years of low yields that drove investors to allocate more to risky investments, income investors can find attractive yields in higher credit quality fixed income. Investment-grade corporate and municipal bonds are offering higher yields than we have seen in several years, and can help investors earn income without excessive risk-taking.