The Structural Case for Fixed Income in the Current Investment Environment
At their September meeting, the Federal Reserve raised interest rates by three quarters of a percent for the third consecutive time. This brought the total rate increase since March to three percent, marking the sharpest monetary tightening in decades. After being late to recognize that inflation taking hold in the economy was more than transitory, Chair Powell’s approach has evolved from targeting a soft landing to a more painful adjustment through a sustained period of below-trend growth. From this statement alone, it sounds like the Fed may be willing to drive the economy into a recession in pursuit of price stability, sacrificing one side of their dual mandate for the other.
While this represents a substantial shift, the Fed is not alone in their approach and a herd of increasingly restrictive policies have been enacted across the globe. In 2022, dozens of central banks have moved aggressively in the same direction, amplifying the effects of each other’s activity in the process.
Figure 1: 40+ Central Banks Enacted Individual Hikes of 0.75% or More in 2022
Source: Bloomberg
This growing dynamic adds a new element of uncertainty to what were already fragile economic conditions that have been complicated by supply disruptions and geopolitical conflict. As noted in the World Bank’s mid-September report, central banks’ “mutually compounding effects could produce larger impacts than intended” when they flow through markets to the economy. With that backdrop, it can be useful to look at the impact this widespread escalation of restrictive policy has already had on markets to get a clearer picture of where we are and what might happen moving forward.
The Policy Shift’s Impact on Markets
As described above, the Fed has raised interest rates from 0.25% to 3.25% in 2022, and at the time of writing Fed Funds futures implied a 2023 peak overnight rate of just over 4.5%. This market-based measure is within striking distance of the expected level of rates from the Fed’s most recent Summary of Economic Projections (though it’s worth pointing out that despite their role setting monetary policy, the Fed’s own projections for interest rates have been notably inaccurate this year). With that being said, these datapoints provide a frame of reference for the forward path of rates currently priced by markets which is naturally embedded in pricing across fixed income.
The sweeping shift in actual and expected monetary policy on the year has driven a sharp recalibration of asset prices. While stocks have certainly suffered, the fixed income side of portfolios has come under direct pressure as the rapid increase in base rates has driven a rise in yields across the spectrum.
Figure 2: Yield-To-Worst Across Fixed Income Markets, 12/31/21 vs. 9/27/22
Source: Bloomberg, see index definitions for additional information
The pricing reset illustrated in Figure 2 has been both broad and deep within fixed income markets, and in a longer-term historical context, 10-year US Treasury yields have risen more in 2022 than any other year on record going back to 1962. Yields can only provide a one-dimensional view of this changing landscape without incorporating key factors such as default risk, inflation adjustments, and unexpected future changes in rates that aren’t yet priced by markets. With that being said, the data above plainly shows a structural shift in potential risk and return across the asset class, where markets from Treasuries to investment grade bonds and high yield credit now offer yields that have rarely been seen over the last decade.
As is often the case with out-of-favor assets, the opportunity set for investing in fixed income has grown considerably in a year when overwhelming selling pressure has dominated pricing. With full knowledge of what has already taken place in these markets, thinking probabilistically about future risks and how you’re compensated for them can be valuable when positioning portfolios in an investment landscape that has shifted meaningfully in recent months.
What Could Happen Next for Policy, Markets & the Economy?
In the same way we can see the impact that policy has already had on markets, we also know the market’s expectations for future policy through the forward path of interest rate hikes priced by Fed Funds futures as discussed above. This expected path provides a baseline for future policy decisions and importantly reflects the level of further monetary tightening now priced into other financial assets.
Figure 3: Expected Future Path of Three-Month Average Fed Funds Rate
Source: Federal Reserve Bank of Atlanta
As noted, the monetary path shown in Figure 3 is already reflected in market pricing so changing expectations around these policies and their impact are set to drive markets moving forward. Given this and how long it takes policy changes to impact the economy, we’re at an important juncture where a narrowing path to a soft landing has given way to more challenging conditions and rising risks of policy errors on either side of the Fed’s dual mandate.
When considering the inflation side of this policy dilemma, levels remain well-above target and growing evidence of demand pressure, not transitory forces, has left central banks playing catch up with an acceleration of tightening cycles across the globe. Although commodity prices have fallen, many core components of the Consumer Price Index have yet to slow and failing to tighten sufficiently to stem these pressures remains a key risk where high inflation could become further entrenched.
On the other side of the Fed’s mandate, monetary tightening has yet to materially impact employment but it may only be a matter of time before this starts to bite. Shown below in Figure 4, growth expectations among forecasters have been revised downward consistently throughout the year, and indicators from falling house prices to inverted yield curves continue to point to slowing activity. As central banks across the globe hike aggressively into increasingly fragile conditions, the risk of going too far is also considerable with the odds of a 2023 recession on the rise.
Figure 4: Declining Growth Forecasts for 2023
Source: Bloomberg Economist Surveys
Amidst strong economic and policy crosswinds, markets can break either way, and understanding what this means for risks across asset classes is essential when thinking about how to position portfolios for a wide set of potential outcomes. Concentrating in equities could be advantageous if the Fed threads the needle and the economy lands more softly than expected, but this approach can also leave portfolios exposed to the growing risk of a recession highlighted above. Fixed income, on the other hand, may offer greater protection with the ability to harvest higher yields that are now available as the impacts of restrictive policies take hold in the economy.
Even with higher yields across fixed income, there is importantly no free lunch as rates may continue to rise beyond the steep path of tightening priced in and credit conditions may also deteriorate. With markets where they are, however, the available yields now have a greater ability to offset the impact from changing prices than they had at the start of the year – a critical change when looking through the lens of total returns. It has been a long time since yields have offered this level of impact, and while challenging in recent months, the reset in market pricing should be a welcome development for fixed income’s role in portfolios moving forward and the opportunity set over the long-term.
Adapting Portfolios to a New Set of Potential Risks and Returns
The developments around policy and its economic impact highlight what investors already know – that the Fed’s monetary tightening to fight inflation is simultaneously increasing the odds of a recession. While a downturn will come eventually, knowing exactly when, how deep, and how long it might last would require a crystal ball that we don’t have.
When thinking about investing through uncertain conditions like these, however, the economic relationships embedded within financial assets can be used to build portfolios that seek to harvest balanced returns without having to time or predict exactly where we are in the cycle. Fixed income assets in particular – from government bonds to corporate credit – feature a differentiated set of relationships to changing economic conditions that can help fill in the critical gaps for portfolios.
As the environment for policy, markets and the economy has evolved over the course of this year, the prospects for risk and return across asset classes have changed. Understanding these changes and the relationships that support them can help investors prepare portfolios for a notably wide set of potential outcomes as the global shift in monetary conditions flows through financial markets and into the real economy.
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INDEX DEFINITIONS:
1-3m US Treasury: Bloomberg U.S. Tr Bills: 1-3 M Index
1-3y US Treasury: Bloomberg U.S. Treasury: 1-3 Y Index
3-5y US Treasury: Bloomberg U.S. Treasury: 3-5 Y Index
7-10y US Treasury: Bloomberg U.S. Treasury: 7-10 Index
20y+ US Treasury: Bloomberg U.S. Treasury: 20+ Y Index
US Inflation-Linked: Bloomberg US Treasury Inflation-Linked Index
Mortgages: Bloomberg US MBS Index Total Return Index
Municipals: Bloomberg Municipal Bond Index
Inv Grade Corporates: Bloomberg US Corporate Total Return Index
High Yield Corporates: Bloomberg US Corporate High Yield Index
EM Debt (USD): Bloomberg EM USD Aggregate Total Return Index
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