Bond Market: Waiting for Liftoff

The Federal Reserve has set in motion a plan to tighten monetary policy to combat high inflation. Based on comments from Fed Chair Jerome Powell following the central bank’s most recent policymaking meeting, “lift off”—as the first rate hike of the cycle is called—will almost certainly occur at its upcoming March 15^th-16^th policy meeting. Quantitative tightening, the process of reducing the amount of bonds the Fed holds on its balance sheet, is likely to start soon after the start of rate hikes.

The bond market has taken the Fed’s signal and run with it. The market is pricing in five rate increases of 25 basis points each, which would put the federal funds rate at 1.25% by the end of the year (a basis point is 1/100^th of a percentage point). That’s a huge jump from where the market was priced just a few months ago, and there are plenty of predictions that rates could move even higher.

The bond market is now pricing in five rate hikes this year

The World Interest Rate Probability (WIRP) data represents the estimated number of moves priced into the current forward-curve structure for the United States using the futures model.

Source: Bloomberg. WIRP Estimated number of Moves Priced in for the U.S. - Futures Model (US0ANM DEC2022 Index).  Data as of 2/1/2022.

Flight plan is still pending

While it’s clear that the Fed is anxious to initiate a new tightening cycle, we think it’s premature to forecast such a rapid pace of rate hikes without more clarity about its plans to reduce the amount of bonds the Fed holds on its balance sheet. The Fed released general principles for quantitative tightening, but hasn’t spelled out a clear plan yet.

The Fed's balance sheet has ballooned to more than $8 trillion

Source: Bloomberg. Reserve Balance Wednesday Close for Treasury Bills, Treasury Notes, Treasury Bonds, Treasury Inflation Protected Securities (TIPS), and Mortgage Backed Securities (MBS). Weekly data as of 1/26/2022.

Allowing bonds to mature without reinvestment can have a similar impact as  hiking rates in terms of the impact on the availability of funds to the banking system. The Fed has indicated it prefers using the federal funds rate as its primary tool to set policy, but given the size of its current bond holdings, it’s possible that quantitative tightening will play a bigger role in the Fed’s plans in this cycle than it did in the last cycle. That could mean fewer rate hikes than anticipated. Economists have estimated that a $600 billion reduction in the balance sheet is the equivalent of about a 25-basis-point rate increase.¹

Moreover, amid the volatility in the economic data, there are already signs that the economy is slowing down as we enter 2022. Inventories that were built up late last year likely will be drawn down in the first half of this year, while the pace of manufacturing orders has started to decline. Consumer spending has slowed as pent-up demand for goods has been met and savings have been drawn down. In 2022, fiscal policy will provide less of a boost to incomes, as higher mortgage rates should cool down the housing market.

Swings in economic growth have been among the widest in modern history

Source: Bloomberg. U.S. Gross Domestic Product (GDP) quarter-over-quarter (QoQ) seasonally adjusted annual rate (SAAR), U.S. GDP Personal Consumption QoQ SAAR, U.S. GDP Private Domestic Investment QoQ SAAR, U.S. GDP Exports QoQ SAAR, U.S. GDP Imports QoQ SAAR, and U.S. GDP Government Purchases & Investment QoQ SAAR (GDP CQOQ Index, GDPCTOT% Index, GPDITOC% Index, GDPTEXP% Index, GDPTIMP% Index, GPGSTOC% Index). Quarterly data as of 12/31/2021.

Expect turbulence to continue

Fed Chair Powell has indicated that policy plans are not on a set course, with the Fed preferring to take a “nimble” approach. However, the markets have discounted a significant tightening in policy for this year. The telltale signs of tight policy expectations are already showing up in the markets. The yield curve has flattened, with short-term rates moving up sharply relative to long-term rates.

The spread between 2- and 10-year Treasury yields has fallen, flattening the curve

Note: The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y10).  This spread is a calculated Bloomberg yield spread that replicates selling the current 2-year U.S. Treasury note and buying the current 10-year U.S. Treasury note, then factoring the differences by 100. Past performance is no guarantee of future results.

Source: Bloomberg. Daily data as of 2/2/2022.

Real Treasury yields—adjusted for inflation expectations—have risen steeply in the past few months. The yields are still negative, but well off the levels seen late last year.  Negative real yields are usually associated with periods of weak economic growth and high global savings, where demand for safe securities exceeds the supply. Investors accept the low yields relative to inflation because they expect inflation to fall, or because they are seeking safety over returns. With the economy improving and the Fed ending its bond-buying program, it’s not surprising that real yields are moving up. That suggests that riskier segments of the market, where investors may have stretched to capture positive real yields—such as high-yield bonds—may underperform as after-inflation returns on Treasuries become more attractive by comparison.

Real yields are still negative but are rising

Source: Bloomberg. US Generic Govt TII 10 Yr (USGGT10Y INDEX) and US Generic Govt TII 5 Yr (USGGT05Y INDEX).  Daily data as of 2/2/2022.As of 2/2/2022.

The U.S. dollar has spiked to its highest level in two years, reflecting the high level of U.S. short-term yields relative to yields in other major developed countries.

The Bloomberg U.S. Dollar Index has risen

Source: Bloomberg. Bloomberg Dollar Spot Index (BBDXY Index). Daily data as of 2/2/2022.

In the corporate bond market, credit spreads—the extra yield that investors demand over Treasury yields to compensate for risk of default—have moved up from the very low levels of last year. It’s a sign that rising real rates are beginning to pull investment dollars away from riskier bonds amid concerns about the impact of Fed tightening.

High-yield bond spreads are at the highest level in nearly a year

Source: Bloomberg, using daily data as of 2/1/2022. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. Past performance is no guarantee of future results.

Finally, the recent shakeout in speculative areas of the equity market is also a sign that markets expect tighter monetary policy to have a negative effect on the returns in highly leveraged investments.

Destination neutral

In the long run, the Fed’s goal is to sets policy rate at “neutral,” a level that allows the economy to grow at its potential without generating inflation. The Fed’s estimate of the neutral level of the federal funds rate is 2.5%. However, it only touched that level once in the past decade—in 2018—and that didn’t last long. While it’s possible that the neutral rate has moved up or that Fed will need to raise the federal funds above the neutral rate due to high inflation, such a move would raise the risk of leading to a recession.

With the markets now priced for the fed funds rate above 2% over the next years, it has gone a long way to discounting a cycle of Fed tightening.

What to do while waiting for liftoff

We continue to see upward pressure on yields as the Fed’s liftoff date approaches. We wouldn’t fight the trend, preferring to keep the average duration in portfolios low. However, as the Fed’s plans become clearer, we are looking for potential opportunities to invest in intermediate- to longer-term bonds at higher yields. Buy-and-hold investors with a long-term time horizon can consider adding duration in high-quality bonds, such as Treasuries and investment-grade corporate and municipal bonds.

¹ “The Hutchins Center Explains: Quantitative Easing,” The Brookings Institution, January 21, 2015.