August 15, 2022
Global Fixed Income Strategy Team
Fixed income in 2022 — Navigating through the challenges
- We expect the Federal Reserve (Fed) to continue hiking interest rates through the second half of the year and into 2023. This may cause the magnitude of the yield curve inversion to be larger than what it has been in the previous two cycles.
- We believe falling Fed monetary support and tightening financial conditions could potentially provide a shock that reduces bond market liquidity.
What it may mean for investors
- Although we acknowledge that investors are not accustomed to seeing price declines in bonds (especially not double-digit declines in a six-month period), this truly has been a historical outlier. We still believe that historically, bonds have tended to be less risky than stocks over the long term and have provided portfolios with diversification and overall less volatility.
Investor concerns around the performance of fixed income assets have been a regular theme so far in 2022. We have conducted research and published several reports on the factors that are contributing to the current challenging environment. The intent of this executive summary is to address at a high level some of the recurring questions we have been hearing from investors. These are the top 10 questions on fixed income investors’ minds.
1. What is happening to bonds so far in 2022?
The first half of 2022 took many investors by surprise, as both equity and fixed income markets experienced negative returns simultaneously. Although all major fixed income indexes recovered in July as yields declined, they are still negative year-to-date.
Historically, during stock market selloffs, investors have tended to move to bonds as a perceived safe-haven asset, driving bond prices higher and yields lower. However, this trend broke in the first half of the year, leading some investors to question the value of owning bonds as a potential portfolio stabilizer.
Several macroeconomic trends contributed to the underperformance of bonds. Most of the decline in prices and rise in yields can be attributed to elevated inflation levels, aggressive monetary policy tightening by the Fed, and shrinking investor appetite for fixed income during a rising-rate environment.
2. Why continue to invest in bonds?
Interest rates have risen across the maturity spectrum (also known as the yield curve) and we believe bonds should still provide income, even if prices decline.
We believe that most of the increases in interest rates for this cycle are in the rearview mirror, and better entry opportunities will present themselves if yields peak sometime in the second half as we expect.
Although we acknowledge that investors are not accustomed to seeing price declines in bonds (especially not double-digit declines in a six-month period), this truly has been a historical outlier. We still believe that historically, bonds have tended to be less risky than stocks over the long term and have provided portfolios with diversification and overall less volatility.1
3. Why is the Fed garnering so much attention this year?
The Fed is on a mission to combat inflation. It has deployed two of its main tools (raising the federal funds target rate and selling financial securities on its balance sheet) in an effort to achieve its stated goal of bringing inflation back to 2% or slightly above that level.
When the Fed implements these policies, it can trigger a chain of events that affect other short-term interest rates (for example, credit cards and auto loans), foreign exchange rates, long-term interest rates (such as home mortgages), the amount of money and credit available in the financial system, and — ultimately — a range of economic variables, including employment, output, and prices of goods and services.
Investors are concerned that the Fed will not be able to engineer a gradual slowdown, or “soft landing,” and that it will inevitably tilt the economy into a recession as it tries to rein in inflation.
4. What should investors expect from the remaining three Fed meetings of this year?
All of the remaining Fed meetings are crucial, as the Fed has signaled that it will continue to hike rates aggressively to bring inflation under control. The new “dot plot”2 from Fed officials now prices in a terminal rate of 3.8%, which implies an additional 125 basis points (bps; 100 basis points equal 1%) increase by year-end 2023, from 2.50% currently. It is our belief that the Fed will see no choice but to increase rates further, even beyond most recent market expectations.
Our base case path for interest rate increases is for the Fed to raise rates by an additional 75 bps in September and by 25 bps in both November and December. We believe it will raise rates two more times in 2023 — by 25 bps each.
5. What does Fed quantitative tightening mean?
Quantitative tightening — or “QT” — refers to the Fed’s plans to reduce its securities portfolio. The current QT program started in June, when the Fed began allowing maturing securities in its portfolio to “roll off.” The amount of securities rolling off will be subject to monthly caps — for U.S. Treasury securities, the cap is set at $30 billion per month until August, increasing to $60 billion per month thereafter. For agency debt and mortgage-backed securities, the monthly cap has been set at $17.5 billion for the first three months, increasing to $35 billion thereafter.
We believe that the Fed’s balance sheet will shrink by almost $1.5 trillion by the end of 2023, taking it to around $7.5 trillion, or below 30% of nominal gross domestic product (GDP). If QT proceeds as expected, this $1.5 trillion reduction in the balance sheet could be equivalent to another 75 to 100 bps of tightening according to Fed staff reports.3
6. What do you mean when you say, “financial conditions in the economy are tightening”?
Financial conditions can be broadly summarized by five key measures: short- and long-term Treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices. When we say that those conditions are tightening, it means that the values of those indicators are becoming more adverse toward the saving and investment plans of households and businesses. In other words, it becomes more difficult for individuals and companies to borrow money.
U.S. financial conditions already have begun tightening, and this is occurring at a faster pace than what investors experienced in the last Fed tightening cycle. Most of the recent change in the Chicago Fed’s National Financial Conditions Index4 can be attributed to a broad-based widening of credit spreads, declining valuations, and an increase in equity and bond market volatility.
Financial conditions historically have indicated future inflation trends, so their rapid tightening could eventually ease some of the stickiness and broadness of inflation pressures. However, although effective in terms of controlling inflation, aggressive interest rate hikes and QT may cause economic activity to weaken and unemployment to rise, at the same time stubbornly high inflation could begin to yield some ground.
7. Should we be worried about liquidity in bond markets?
Liquidity is the ability to buy or sell a security in a reasonable period of time within an expected price range. When the stock or bond market is not liquid, an investor may not be able to transact a security at the desired price or time, or both. Historically, liquidity has declined when risks increase, especially those risks that seem to surprise the market in terms of timing or magnitude.
We believe falling Fed monetary support and tightening financial conditions could potentially provide a shock that reduces bond market liquidity. The risk of a sudden decline in bond market liquidity has historically increased as the bond markets moved through the latter stages of an economic expansion and into the economic slowdown and eventual recession. The Fed has noted that liquidity has been declining since late 2021, and although not as extreme as in some past episodes, the risk of a sudden significant deterioration appears higher than normal.
We favor determining liquidity and risk tolerance needs with an investment professional and updating this information as it changes. We believe a portfolio should reflect these needs and diversify appropriately between more-liquid and less-liquid investments. Investors should also evaluate holding size, time to maturity, and bond asset class (for example, government, corporate, or securitized) in an effort to arrange the best opportunity for improved liquidity. An example of more-liquid fixed income assets are those of high-quality investment grade companies, while less-liquid bonds are usually those of high-yield issuers.
8. What is the shape of the U.S. Treasury yield curve telling us?
The Treasury yield curve remains one of the best leading indicators for investor sentiment about inflation and economic growth expectations, in our opinion. Additionally, the shape of the yield curve has historically been a reliable predictor of a recession in past economic cycles. We believe we are at a key inflection point, as our forecasts for the second half of the year point toward more curve flattening — yields the same or close across maturities — and even a continued yield curve inversion,5 when short-term yields exceed long-term yields.
We expect the Fed to continue hiking rates aggressively at a time when economic growth is declining. This may cause the magnitude of the yield curve inversion to be larger than what it has been in the previous two cycles, and the yield curve could very well remain inverted through the recession.
Investors may want to consider adding more capital to longer-term bonds in anticipation of the economic slowdown and a potential further decline in equities. Also, if investors believe the Fed will not only stop hiking rates but also reverse trend and begin cutting rates soon, this may also support longer-term maturity bonds.
9. What is our view on high-yield (HY) fixed income in the current environment?
We have an unfavorable view of HY fixed income. Rolling 12-month performance in the HY asset class has been deteriorating at a rapid pace since the beginning of the year, although performance improved somewhat in July. The strong pace of interest rate increases from the Fed, coupled with a change in credit risk sentiment, has caused HY spreads over comparable-maturity U.S. Treasuries to widen from the near all-time lows seen in July of 2021.
The main threat for HY fixed income over the next year, in our view, likely will come from further monetary tightening and the deterioration in credit conditions as economic growth slows. Historically, HY spreads have tended to widen as financial conditions tighten. We expect a recession as our base case for the end of 2022 and early 2023, which should cause further spread widening and HY underperformance. Credit default swaps in the HY sector are already pricing a challenging environment.
While the HY asset class should continue to provide investors with better yields than more traditional fixed income asset classes, we believe better opportunities exist in other investment grade (IG) fixed-income sectors in the current environment. We remain neutral on IG corporates as companies with stronger balance sheets and less leverage tend to be more resilient during economic downturns.
10. What is our preferred fixed income positioning in the current environment?
For now, short and intermediate maturities are our current maturity preference for investment-grade taxable and municipal fixed-income investors. However, we emphasize that we also favor bringing long-term maturity allocations up to even weight (neutral) within our strategic asset allocation levels.
While this guidance retains a defensive posture in our overall fixed-income positioning, we view this as a step toward a more constructive view on longer-term maturities.
Once we have confidence that the economy has turned the corner on inflation, we may shift to favor longer maturities.
1 Why own bonds? Wells Fargo Investment Institute, June 2021.
2 Federal Open Market Committee officials’ expectations of fed funds interest rate over the next 2 years and longer term. Summary of Economic Projections as of June 15, 2022.
3 Based on two Fed studies: Forecasting the Stance of Policy under Balance Sheet Adjustments by Troy Davig and A. Lee Smith, May 2017; and Substitutability of Monetary Policy Instruments by Cynthia Doniger, James Hebden, Luke Pettit and Arsenios Skaperdas, July 2019. One basis point equals one hundred of one percent, or 0.01%.
4 The National Financial Conditions index (NFCI) is constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1971. Positive values of the NFCI have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions.
5 For more information about yield curve inversion, please refer to our In-Depth report: “The predictive power of yield curve inversions, April 20, 2022.
Forecasts and targets are based on certain assumptions and on views of market and economic conditions which are subject to change.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.
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