How to Prepare for Landing

In keeping with the aviation theme, the debate brings to mind a saying among pilots: "Any landing you walk away from is a good landing." In other words, if you can survive the landing intact and without injury, you've succeeded. We see that as a worthwhile perspective for investors. It's more important to survive the landing than to guess its force.

Not surprisingly, expectations for where the federal funds rate will peak continue to rise. The market is currently pricing in the potential for the rate to go as high as 5.25% to 5.5% this year—up 50 basis points (or 0.50%) in the past month alone. Some Federal Reserve officials have even indicated that short-term rates may need to rise to 6% to slow economic growth and cool inflation. That is likely a "hard landing" scenario.

In our view, the most likely outcome is another 25-basis-point hike in the target range for the federal funds rate, bringing it to 4.75% to 5.0%. Having just reduced the size of its rate hikes in January, we doubt the Fed will want to shift gears again so soon. However, the median estimate for the peak fed funds rate—often referred to as the terminal rate—could rise as the Fed assesses how much more tightening is needed to slow inflation.

Nonetheless, because changes in monetary policy can take a long time to affect inflation, it makes sense for the Fed to slow down the pace of rate hikes after a year of aggressive tightening. Moreover, there are signs that policy is already "restrictive"—tight enough to slow economic growth and reduce inflation.

The spread between two-year and 10-year Treasury yields has fallen to nearly minus-90 basis points, the deepest inversion since the 1980s. In the past, an inverted yield curve has been a reliable indicator of recession within 12 to 18 months. However, the severity of a recession has varied and hasn't correlated to the depth of the inversion.

Even the Fed's preferred yield curve indicators—the "forward curve," or the spread between current three-month yields today and the implied yield on three-month yields a year and a half from now—is pointing to a rising risk of recession. At 4.6%, it is the highest since 2007.

The goal should be to walk away from the landing—whatever form it takes—without significant losses or declines in portfolio values. We suggest focusing on bonds high in credit quality, such as Treasuries and investment-grade corporate or municipal bonds, while gradually adding to duration until it reaches your benchmark level. Duration refers to the sensitivity of a bond's price to changes in interest rates. In general, short-term bonds have lower durations than long-term bonds. A common benchmark duration tracked by fixed income investors is the Bloomberg Barclays Aggregate Bond Index. Its duration is currently about 6.2 years. For investors who are more risk-averse and holding a significant amount of fixed income in very short-term maturities, we suggest moving out to at least two- to three-year maturities to avoid reinvestment risk—that is, the risk of being forced to reinvest at a lower yield while yields are dropping. In past cycles, when the peak in rates has been reached, yields have tended to fall quickly as the market adjusts its expectations for the path of Fed policy and inflation.

Overall, whether it's a hard or soft landing, yields are likely to decline. In the meantime, we would be prepared for a bumpy ride.